Adding Basis Points

A reader left the following on a post the other day;

" I'm happy if I can add 100 basis points of yield above the benchmark and would be thrilled with 150 basis points "

I would be interested if you could post an analysis of why this is so.

An important building block to understanding portfolio construction is that historically US markets have returned 9-10% on an annualized basis of which some portion of that return coming from dividend yield. Lately that yield has been in the neighborhood of 2%. A reasonable aspiration for a long term result would be to achieve returns somewhere close to that 9-10% which along with a proper savings rate will be most people's best shot at having enough when they need it.

Once that building block is taken to heart, time ideally is then spent on understanding the various behavioral biases that impede success. Once a little introspection is found I would then move on to understanding the big picture in the world, how and when to look like the world (the broad index that serves as the benchmark) and when not to look like the world. Also part of this can be personal assessment about how to generally navigate market cycles in a manner that allows for sleeping at night.

Against that backdrop I worked through the above process to conclude broad diversification with narrow products (individual issues and specialty ETFs) looking to mostly, repeat term coming, smooth out the ride for clients over the course of the entire stock market cycle was right for me.

If in a overly simplistic example the market returns 10% every year with some portion from gains and some from yield then the more that comes from yield the less volatility the rest of the portfolio needs to be exposed to. In a more practical sense if up a little is the most common outcome in a given year then extra yield can allow for a slightly less volatile portfolio (so a better risk adjusted result) but still allow for what I think of as proper diversification in terms of countries, themes and holdings with varying attributes such that there are no lopsided exposures that could hurt the portfolio in an extreme manner.

In my experience there a couple of risk factors that go with too large of a yield. One is that if every stock in a portfolio yields 4% then there is a good chance that the portfolio misses all sorts of market segments so then the give up is diversification. The other risk factors, and this is more of a big picture concept is that, as an example, a 6% yield in a 1% world takes some amount of risk. The end user may or may not understand the risk but it is there.