Pay Attention to the Weightings of Your Individual Holdings When Constructing a Portfolio
One of the things that worries me from a risk management perspective is investors who don’t know what they own or their actual, real portfolio weightings. Sometimes, I’ll hear new investors say, “I own stocks” or “I own mutual funds” but neither is an answer. Those aren’t the relevant details. The real question: “In which enterprises, on what terms, and at what price has the money been invested, laid out, and exchanged?”. Much of everything else is a smokescreen serving to obfuscate reality. It’s risk-adjusted reward we’re after; reward measured in after-tax, net-of-inflation real purchasing power.
To explain what I mean, let me take a round-about journey, re-visiting some ground we’ve discussed in the past. This will let me frame the discussion in a way that should clarify the underlying point so that it emerges organically.
Let’s imagine you have $100,000 in a portfolio. You call this portfolio “The Blue Portfolio”. It is divided into four companies (in reality, you’d have many more as it would almost never be prudent to have all of your wealth divided solely into four companies absent an extraordinarily good reason but let’s keep it simple for the sake of efficiency as the concept is what is important).
- 25% into Company A, a sporting goods business
- 25% into Company B, a software business
- 25% into Company C, a coffee business
- 25% into Company D, an oil company
At the end of the year, the portfolio has increased in value by 11%, to $111,000. The weightings of your holdings are as follows:
- Company A has grown to $32,000
- Company B has declined to $21,000
- Company C has grown to $41,000
- Company D has declined to $17,000
Of course, as most of you know, from both an academic and pragmatic vantage point, it is nonsensical to measure your equity returns over periods of twelve months. At the very minimum, a holding period of five years is required to begin to reduce price fluctuations and let intrinsic value exert its gravity-like force on the mercurial market price. You’d behave this way when looking at an apartment building, the copyright to a novel, a royalty stream from mineral rights, or a private business so partial ownership of public enterprises should be no different. In fact, when you’re dealing with certain businesses such as the oil majors, you need measurement periods that are much longer than that because you, as an owner, are being paid to absorb volatility, typically receiving above-average market returns over decades in exchange for multi-year periods of extreme distress. As long as the underlying components in The Blue Portfolio are fine, the key to success for most investors is going to be passivity; regularly buying and holding, perhaps reinvesting dividends, keeping costs low, and letting time work its magic.
Of the three primary ways most investors put money to work – systematic accumulation, valuation-based accumulation, and market timing (the latter of which is de facto speculation and cannot be done consistently with any degree of predictability) – the mechanics may differ based on factors such as personality, cost, and convenience.
For example, if you were taking a systematic accumulation approach, you might:
- Regularly contribute a fixed amount of money and divide it equally among the components of The Blue Portfolio; e.g., you deposit $400 a month and invest $100 each into shares of Companies A, B, C, and D.
- Match the existing market-weights at the time of the deposit; e.g., you deposit $400 a month into your portfolio with this month, you put $115.32 into Company A, $75.68 into Company B, $147.75 into Company C, and $61.25 into Company D to maintain the ratios that have naturally developed.
On the other hand, if you were taking the valuation approach, you would analyze each holding, calculate the net present value of the owner earnings using different probability assessments so you could build in a margin of safety, and then, after looking at your overall risk profile, make allocation decisions. You might decide that Company C has much better underlying intrinsic value than you realized while Company D is undervalued due to fear in the sector, splitting the $400 into two piles of $200 each, adding to those two components. Or, if you invest on a basket-basis, you might decide that the entire Blue Portfolio is too expensive relative to bonds and sell some off to buy fixed-income securities.
We’ll skip the market timing approach. It’s neither relevant nor advisable.
When you understand that this is what is really going on with equity portfolio construction – it’s all just individual stocks with the specific weightings determined by the methodology the investor has selected, whether it be outsourcing the rules to a committee, as in the case of an S&P 500 index fund, picking up an equally-weighted ETF focusing on a single sector as part of a diversified portfolio, or hand-building each component in the old-fashion, Benjamin Graham school, insofar as risk can be managed, everything, in the final analysis, comes down to 1.) which companies you own, 2.) the proportion in which you own them, 3.) the combination of earnings growth and dividend yield of those holdings (the drivers of total return from an operational perspective), and 4.) the valuation multiple applied by other investors. That’s it. Everything else is a distraction or merely ancillary to the core reality unless you’re dealing with some sort of esoteric strategy that is wildly inappropriate for most people, such as converting volatility into an asset class of its own and profiting from the willingness to absorb risks for third-parties (e.g., writing cash secured equity puts with surplus funds or selling covered calls against holdings you already have on your books).
When You Think In Terms of Underlying Holdings, You Realize How Mathematically Bizarre or Misguided a Lot of Statements Can Be from a Portfolio Weighting Perspective
It’s a concept that every investor should internalize because it makes it much more difficult to lose your minds with crowds as you are forced to focus on the underlying foundation; what you really own; the engine that is generating wealth for you. It reframes everything in your mind so you see the actual, net effect, both in risk exposures and potential rewards, of suggested changes to your assets.
Let me give you an illustration. Recently, there was an article published at BloombergGadfly called Exxon Is the Coldplay of Oil Stocks. It contained this passage:
Yes, Exxon’s total return last year, including its sacrosanct dividend, of negative 12.8 percent was much better than the SPDR E&P ETF’s negative 35.8 percent. Yet Exxon still lagged behind the S&P 500’s total return of a positive 1.4 percent.
So if it is scale, diversity, and dividends that you value and you think energy is due another bad year, then why not just own the market rather than Exxon?
Immediately, you should recognize the question, as presented, doesn’t make any sense. What is the actual question? Let’s say that you use the largest domestic definition of “the market” and search for one of the best ways to accumulate it at the lowest cost. Assuming you’re investing through a tax shelter, one of my favorites for the task would be something like VTSMX, which is the Vanguard Total Stock Market Index fund so we’ll go with that (if you have an objection, insert your own favored fund here). The methodology employed, subject to some of the same caveats we discussed pertaining to the S&P 500 equivalent, means that the real inquiry being posed is, “Why buy shares of Exxon with this pile of money? Instead, you should put 3.01% of your cash in Apple, 1.95% in Google, 1.75% in Microsoft, 1.52% in Exxon, 1.26% in General Electric, 1.25% in Johnson & Johnson, 1.14% in Wells Fargo, 1.11% in Amazon, 1.10% in Berkshire Hathaway, 1.10% in JPMorgan Chase, 1.00% in Facebook,” and on and on it goes.
It other words, you can quite literally rephrase the question as “Why not just [put 1.52% of this new deposit into Exxon] instead of [an undisclosed percentage that has not been, and will not be, discussed at any point in the article] Exxon?”, cutting right to the heart of the matter. Mathematically, that is what is happening; the nuts and bolts of the figures no matter what kind of language is used to describe it. I walked you through a similar example in much more detail in a post called What Do You Think of Rod’s Investment System?, which breaks down the fallacy that “the market” exists. You can’t buy the market because there is no such thing as the market. There are only individual stocks, at specific weightings, with specific rules. The key to success, at the risk of repeating myself: You want reasonable costs, good tax efficiency, long holding periods that favor passivity over frequent trading and activity (along with all the costs that such behavior generates in not only commissions but ask/bid spreads), and acceptable levels of diversification. How you do that is less important as long as you do it. It’s going to differ for everyone based upon their own opportunity costs.
To be blunt about it, if you hear someone say, “Why do you own [insert shares of company here] when they were [insert performance here] when you could just own the index, instead?”, realize that it is a mathematically ridiculous question. For someone to state it indicates they truly have not internalized the math and structure of how the whole system works. The odds are good the index itself owned that particular security for heaven’s sake. The only relevant consideration is how the entire portfolio performed, which is influenced by the portfolio weight you’ve assigned to that component. Stated another way, the question is as nonsensical as calling Fidelity or Schwab, Vanguard or T. Rowe Price and demanding to know why the S&P 500 index fund invested in shares of Apple when it could have invested in the S&P 500, instead. Anyone who is familiar with the mechanics is likely to bang their head on the table. It makes no sense. None. It’s not how it works. Peter Lynch at Fidelity used to write about how this weird focus on individual components rather than their relative contribution to the total return of the portfolio led to all sorts of bad incentives and behavior on the part of portfolio managers who gave into the pressure to please these arithmetic dumb dumbs. Investors, in other words, get what they deserve in a lot of cases; how the asset management industry had been effectively incentivized into doing what was most rational for the employees rather than the investors because the investors didn’t know what they were doing. To paraphrase his comments on it, you had portfolio managers who “bought IBM because if it declines this quarter, the question is ‘What the hell is wrong with IBM?’ rather than shares of this really promising, reasonably valued restaurant because if it doesn’t do well, the question will be ‘What the hell is wrong with you?‘ They’d like to keep their job.”. A related practice is known as “window dressing”. It’s crazy but it really happens.
(Side note illustration: If you’re working for an employer offering a limited menu of 401(k) plan options, the optimal choice is almost always going to be a cheap well-run index or value-based fund purchased up to the point of receiving the free matching money. I recently had someone ask me to allocate their 401(k) account after reviewing the choices, the most intelligent thing on the table given their age, risk profile, and current asset allocation outside of the retirement plan was a 67% weighting to the Vanguard Equity-Income Fund and a 33% weighting to a stable value fund paying 1.20% per annum. That wouldn’t have been my first choice if this were a custody account in which I could make any allocation decision I wanted but it was, in my opinion, the best choice all things considered under the set of circumstances this person found themselves. If the long-term managers changed, or I began to not like the valuation and weightings of the underlying portfolio, I’d make a phone call but for now, it was the closest thing to the risk/reward/cost sweet spot on the roster his/her employer provided.)
The point is, looking at an individual component that is part of a diversified portfolio and comparing the component in any given year to the portfolio itself is not an intelligent way to analyze the situation outside of desegregating the measurement period’s total return because it doesn’t get to the core issue: You’re talking about absolute and relative weightings. If someone says, “I’m thinking about adding shares of Exxon to my portfolio”, it’s a nonsensical response to say, “Why not buy the index, instead” because you don’t know the weighting the person is considering. That is vital information that has been left out of the discussion. Rather, the more accurate questions are, “Why do you want to weight Exxon differently than 1.52% of your assets? What weighting are you considering? Is this worth the cost and effort relative to the rewards?”. You’re getting Exxon in both cases. It’s a matter of how much gets stuffed into the basket that is working for you.and your family.
One reason you might want to buy Exxon outright is the practice of tilting your underlying weightings toward assets that have a better risk/reward trade-off, such as increasing diversification or taking advantage of valuation differentials from time-to-time. Imagine you are a 50 year old office worker with $200,000 in your portfolio, all of which is in an S&P 500 index fund; the sole low-cost index option offered by your employer. It can be perfectly reasonable to say, “I don’t have any international stocks so I’m going to open a brokerage account and buy $4,000 worth of Diageo shares and $4,000 worth of Nestle shares with extra money I save over the coming 18 months.” Why? The Diageo and Nestle, both of which are among the best 100 companies in the world in terms of long-term safety and earnings power, are part of a broadly diversified portfolio. You shouldn’t look at them and say, “Oh, [good/bad] they [beat/underperformed] the market this year.” You shouldn’t look at them and say, “I own two individual stocks”. Instead, you should look at them and say, “I introduced two more components in my overall weighting and these are analyzed as part of the S&P 500 index fund I hold in my 401(k).” Desegregate your index funds, break apart your ETFs, and combine the underlying investments with the two individual stocks you own to get a better view of your holdings. The fact that most of your assets are held indirectly doesn’t change reality. The portfolio composition is what matters. They are part of a larger picture.
Morningstar, the mutual fund research giant, has an incredibly cool tool for professional subscribers designed specifically for this purpose. They call it “Instant X-Ray”. You enter the index funds, mutual funds, ETFs, or comparable publicly-traded pooled investments you own, along with any individual stocks, and it produces a report to show you your actual overall portfolio weightings. You can then compare it to a benchmark if you’d like, to see how differently you’ve allocated your assets than your preferred yardstick. This way, you can spot many of your relative risks a lot easier. You can also see how your portfolio looks as a single stock compared to a benchmark (e.g., the p/e ratio, weighted ROA, weighted ROE, projected EPS growth, dividend yield, etc.) It’s particularly useful for uncovering concentrated positions or certain correlated dangers you didn’t realize you had on your books. For example, if you own a dozen mutual funds and index funds but several of them put a big chunk of their holdings in a single firm, you might not realize you’ve hitched your economic wagon heavily to shares of one business; far more than you’d be comfortable with if you held the stocks individually. This tends to be a particular danger during periods of “irrational exuberance”, to borrow a phrase from the former Chairman of the Federal Reserve. If you doubt it, go back to the disclosures of the late 1990’s and start looking at how much capital was concentrated in the top, wildly overvalued technology firms among different mutual funds and index funds. Folks weren’t as diversified as they thought.
Examples of How I Focus on Portfolio Weightings In My Own Life
Why am I telling you this? Simple. No matter how you construct your portfolio – traditional index funds, low-cost ETFs, individual securities held in a custody account – I want you to occasionally ask yourself, “What do I actually own? What are the risks of my underlying holdings?” When you add or subtract an asset from your balance sheet, I want you to take time to inquire, “How does this change my overall risk/reward profile?” Portfolio construction is a skill set that is different, and no less important, than asset selection. It’s not just about finding assets you like. It’s about building a portfolio that achieves your unique goals and objections within risk parameters you can accept.
Here are two real-world manifestations in my own family’s situation:
1. Last week, I was answering a question about the only place in which I use index funds – The Kennon-Green Foundation. In my reply, I said:
“The closest a retail investor could come to replicating the weightings of the individual underlying components held in my family’s charitable foundation by using a mainstream asset management company would be a roughly even split between something like FSTMX or VTSAX, on one hand, and something like EFA or FSIVX on the other. (You could not opt for VTIAX to replace the latter because I purposely avoided direct ownership of many Chinese securities – I want a lot more wonderful businesses like Nestle and Novartis in Switzerland rather than technology conglomerates in Hong Kong trading at 2.5% earnings yields, which is present in the Vanguard equivalent due to a change in the underlying construction methodology. This is because I consider a lot of the Chinese holdings sub-par in both valuation and risk trade-offs relative to their European counterparts, influencing my decision. I’d rather get exposure to that particular market through American, British, French, German, Swiss, Japanese, and Australian blue chips but this has to do with my own preference for risk reduction whenever and wherever possible).”
Despite indexing as a strategy for the privacy reasons I’ve previously laid out on the topic (utilizing a donor-advised structure lets me avoid filing a Form 990, which would be visible to the public), I still focus on the underlying composition of the portfolio as well as the valuation of that portfolio. I didn’t want my charity’s money invested in China except to the extent it was done indirectly through multi-national corporations focused on dominating specific markets, such as Colgate-Palmolive with its toothpaste or Coca-Cola with its beverages. I don’t care about the exotic or getting some sense of excitement from my asset roster. I care about sustainable, predictable earning power relative to the price I pay for it. Many Chinese firms scared me at the time. I didn’t ignore that just because I employed index funds.
2. Despite my frequent praise for things such as VTSMX, explaining how it is often a superior choice for inexperienced investors with smaller portfolios who want to effectively automate their capital at an affordable price with an emphasis on passivity, I don’t own any in my own life because it’s nonsensical for me to pretend like my experience, skill set, and interests don’t exist. This is what I do for a living. This is what I think about when I’m going to bed at night. This is what Aaron and I talk about when we are driving somewhere. If I bought, say, a new block of $100,000 worth of VTSMX this afternoon, I’d be getting 1,820% more Facebook stock in that new holding than I am shares of something like The Hershey Company. That’s madness to me. I don’t have to pretend like I don’t know that.
It matters to my risk preferences. I have no idea what Facebook is worth. I hope the people who own it make a lot of money from it, even if it means they compound at a higher rate than my own assets. I really do wish the best for them. I don’t want to own it, though. Not at this price. I don’t feel satisfied with the probabilities; certainly not enough to put $18.20 into it for every $1.00 in Hershey I bought. A quarter-century from now, I have no idea what Facebook, the business that drives intrinsic value, will look like. I have no idea how much money it will be making. Maybe someone else does. In contrast, I am fairly certain that Hershey, at this price, has what I consider a high probability of turning every $10,000 or so into at least $135,000 over that same span on a total-return basis; much better, in my estimation, than the typical business and the S&P 500 as a whole. I understand its valuation. I understand its product mix. I understand the population growth trends. Though it won’t make you rich overnight, I consider that sort of long-term compounding rate satisfactory with a degree of safety not present in other investments. If I bought more shares of Hershey today, it wouldn’t bother me even if they were to collapse by 50% tomorrow provided the long-term economic engine is still intact because I have no plans on selling them. It wouldn’t bother me if the S&P 500 outperformed it by a 3-to-1 margin over the next 36 months. I don’t care. It is a single component in my overall portfolio, weighted much more heavily than in a comparable index fund. I know what I’m getting, I know what I believe to be the likely potential downsides. I don’t care about the individual firm volatility as the shares are fully paid for and mostly parked in cash accounts because, all else equal and absent non-foreseen events or liquidity needs, Aaron and I plan on holding them until we die, someday leaving them to our future children and grandchildren. Even if there is some sort of failure event, the portfolio construction method we use should ensure we make at least some money (the same way shareholders of Eastman Kodak did despite the bankruptcy) due in no small part to what we consider adequate diversification for our purposes. We should be happy with the outcome. To turn down the opportunity to buy it (and we did recently accumulate a lot more) is not a wise way to behave for no reason other than the fact it may not do relatively well compared to an arbitrary benchmark over the short-term.
This is because I think of myself as being in the business of accumulating profits. I want to buy the most net present value look-through earnings and assets I can whenever I write a check so that I increase the quantity of funds being generated by the economic engine I’ve been building throughout my life; an engine that has made it possible for me to enjoy total freedom over my time without ever having to go to work for someone else. Given how young I was when I started, I’ve spent roughly 23 years of my life with most waking hours buried in financial statements and regulatory disclosures. If you see me walking around Kansas City with a cup of coffee in my hands like I was a few days ago at the Country Club Plaza, it’s probably what’s on my mind. It’s fun to me. I’ve arranged my entire personal and professional life in a way that nobody can force me to sell something because it’s ugly on paper at any given moment because, long-term, more often than not, I’ve proven to myself that my judgment is better than theirs. I know what I own and what I want to own. I know what I paid for it and what I want to pay for it.
The Point of Discussing Portfolio Weighting
There are times when I’ll purposely avoid stating my own conclusions or take-away so you think about a topic on your own. I want you to ruminate on it, coming to an opinion for yourself after considering the variables you think are relevant. In this case, I’m going to be a bit more direct and come out and explain why I’m writing this.
I see a lot of new and inexperienced investors take risks they shouldn’t take. They buy index funds that offer terrible risk/reward trade-offs (e.g., I recently had someone sell a low-cost fixed-income index fund in their employer-sponsored retirement plan after the comparably low-cost advisory firm suggested she buy it because the underlying holdings were mostly made up of – I kid you not – intermediate debt instruments of emerging market sovereign governments. This was a person near retirement in the United States who had no business lending money to the governments of Latin American and Asian countries regardless of the potential return. It would have been better, given his/her unique circumstances, to park it in a 60-month FDIC insured certificate of deposit from Barclay’s for 2.25%.) They buy ETFs that have horrible structural risks (e.g., employing leverage or designed for speculation in that they reset on a daily basis, making long-term profit a mathematical impossibility for reasons they don’t understand). They decide to invest in individual stocks directly and go dump all of their money in a handful of securities they don’t understand, exposing their hard-earned capital to the chance of real losses.
Focusing on the underlying weightings lets you see where your money is actually parked and many of the risks to which you’ve exposed yourself. It can make even novice investors behave more intelligently. For example, let’s say you are 30 years old with $50,000 in your portfolio. You decide to open an account with Fidelity. Focusing on the underlying components is going to lead to better behavior. You might divide your money 37%/37%/16% into the Fidelity Spartan Total Market Index Fund (FSTMX), the Fidelity Spartan Global ex U.S. Index Fund (FSGUX), and the Fidelity Spartan U.S. Bond Index fund, then use that last 10% to augment the holdings you really like; great blue chip companies at attractive valuations that you plan on leaving to your kids so they represent a slightly higher percentage of your composition weighting; e.g., you split it into five $1,000 piles and pick up extra shares of Hershey, Johnson & Johnson, Procter & Gamble, Nestle, and Coca-Cola.
On a long-term basis, you’d have not only lowered your expense ratio (other than the initial commission, the augmented stocks should have no on-going costs) but reduced your risk by slightly tweaking your holdings toward more stable, blue chip enterprises that have survived recessions, depressions, war, inflation, deflation, and countless other variables. That’s a really good, satisfactory portfolio. The underlying holdings are, for the most part, far better than you’re going to get with many other setups. Sit on your behind for the next few decades, dollar cost average into it, and you should be okay. Had you been picking funds off a roster without any examination of the underlying holdings, you might very well have ended up with a lot of junk that you had no business owning.
A sidenote, though: If you tweak your portfolio weightings as in this example, I highly recommend you stick to what you know. Here’s what I mean: If you’re a doctor, you probably have seen the near total domination of Kimberly-Clark products in hospitals throughout the country. All day, every day, the medical community is pumping cash into stockholders’ hands. It is a silent juggernaut off the radar of most investors; a juggernaut that enjoys entrenched advantages that make it nearly impossible to unseat, explaining how the enterprise has been a money-printing machine since 1872. Those earnings make their way into shareholder hands both from long-term appreciation and dividends, driving total return. The dividend record encapsulates this nicely. Take a look at it! Every year, more and more cash shows up. How many people do you know who enjoyed a pay raise at this rate over the past couple of decades?
At the moment, I don’t consider Kimberly-Clark to be attractively valued. In fact, I think it’s slightly overvalued. However, imagine we go into a 1973-1974 style meltdown. Perhaps we experience a 1987-style collapse. These things happen every generation or two. You don’t have to mortgage your house and sell your index funds to take advantage of it. Increase your savings rate, sell off some other assets, and consider bringing it up to a 3% or 4% weighting in your diversified portfolio between the individual shares you own and the shares you hold indirectly through your index funds and mutual funds. In essence, you’re customizing your index fund at the margins without doing anything foolish. It’s okay to behave modestly. This is not Las Vegas. You do not have to put all of your money on black to get rich. Go through life making all sorts of small intelligent decisions and the cumulative effect can be substantial. You get Kimberly-Clark. I’d argue it’s in your best interest to buy it under such circumstances rather than acquiring shares in some energy trading conglomerate that is well outside of your knowledge base.
Other situations involving similar trade-offs might arise from time to time. If you get hired by a start-up and you see, with your own eyes, it is enjoying exponential growth; that the profit is real (it’s not just burning through venture capital funding), new employees are being added, pay raises are being handed out, and that new divisions are being created and expanded, deciding to take advantage of the opportunity to buy shares before the IPO in an employee-only round of equity raising very well could be a good decision. Why, in such a situation, would you run off and put your spare money in shares in other companies with which you are less familiar and that are not nearly as attractive instead of the one that is succeeding right in front of you? In the same way people drive their cars into lakes because they don’t want to question the navigation system instructions, too many people buy into this efficient market nonsense where they allow themselves to be conditioned by others, achieved through social proof and a myriad of mental models, to stop thinking; to turn down opportunities because it doesn’t fit within some orthodoxy. Don’t do it. If you’re looking, a few times in your life, you’ll see something squarely in your comfort zone – something right there, in front of you, that you understand backwards, forwards, upside down and inside out – that is clearly an intelligent thing to do. All the numbers work. You know in your heart it’s legitimate. You are familiar with the variables. If, when these ephemeral gold mines present themselves, you fail to take advantage of it, you have no one to blame but yourself. Maintain your independence of thought. (Likewise, don’t allow others to get you to invest in something that causes you discomfort or that you feel you don’t fully understand. It’s your money. Nobody gets to tell you what to do with it. You don’t have to explain yourself.)
Keep It Simple, Think Independently, and Don’t Let People Bully You Into Things You Don’t Want To Do
Always be thinking about portfolio construction and the actual, underlying assets upon which you’ve staked your future. I don’t care if you buy individual stocks. I don’t care if you prefer index funds. I don’t care if you accumulate REIT ETFs. What counts is that you get your hands on real operating assets producing real cash flows by providing real goods and services at a profit to customers; that you pay a reasonable price for that ownership, that you hold it in a tax-efficient way; that you keep your costs manageable; that you are diversified enough to withstand failure from time to time; that you sit on those assets for long enough to absorb the volatility that is part and parcel with holding securities (the old phrase, “time in the market beats timing the market” sums it up perfectly).
In other words, keep it simple and don’t fall into the “true believer” or “irrational escalation” trap where you start thinking there is only one way to financial independence. If you’re tempted to make big moves, consider that it may be more prudent to tweak at the margins like our Kimberly-Clark example. This is not some religious or political purity test where heretics will be cast into outer darkness. Do whatever makes the most sense in your personal situation as well as what provides personal utility in terms of happiness so you’re more likely to stick with the plan or increase your savings rate; e.g., buy index funds through your 401(k) at work, take advantage of DRIPs for the handful of businesses you want to own directly, pick up high-quality cash-generating real estate in your hometown. It’s not all-or-nothing. As weird as it sounds, you will run into folks that, if you deviate from their preferred system, will have an emotional tantrum. Ignore them. The important thing is your odds are greatly improved if you:
- Spend less than you earn, building a surplus;
- Let compounding work its magic on that surplus over long periods of time (the speed should come from expanding the core economic engine in your life, not your securities portfolio, which is really a way to inventory and expand profits);
- Prefer passivity over lots of activity;
- Stick to what you know and understand.
Most of the other stuff is trivial; mechanisms and means to an end. It’s all about buying cash flows. That is the steak to the sizzle. Get your hands on cash flows. Get your hands on enough that you can sit at home and the money arrives regularly so you have the freedom to determine when, how much, and under what conditions, you sell your time.