The Core and Satellite Portfolio: Funds First, Stocks Second

Buy the fund first. The rest is a question of sizes.

The saver from the first lesson has $15,000 sorted, dated and ready for the long term, and a core and satellite portfolio divides it into two parts that do different jobs. The core is one broad, low-cost fund. The satellite is a smaller group of single stocks you choose yourself, because you like the business, you follow the industry, or you simply want to own a few companies by name.

What the core does

A broad fund owns hundreds or thousands of companies at once. Some track the whole US market. Others track a large index such as the S&P 500. You don’t choose the companies. The fund’s rules do. Its return follows that market’s, minus a small yearly fee.

Low cost matters here because the core holds most of your money for the longest time, and a fee is charged on the whole balance every single year, so a small difference in the expense ratio compounds into a real difference over a couple of decades.

Broad isn’t the same as balanced. Big index funds weigh their holdings by company size, so the largest companies can carry a heavy share, a point the viewpoint on index fund concentration takes further.

What the satellite does

The satellite is where your own judgment goes. You pick the stocks and decide when they go. If you’re right, the satellite adds to what the core earns. If you’re wrong, it subtracts. A small satellite keeps the damage small.

Keep the positions equal to start. Equal sizing stops you from putting the most money on whichever idea you feel strongest about this week, which is often just the one with the loudest recent headlines, and loud headlines say little about how a business does over the next few years.

Pick stocks you can explain. Write one line per stock at the time you buy it, saying why you own it, because that line is what the sell rules at the end of the course test against, and a reason you never wrote down is easy to rewrite after the price has moved.

The worked example

The saver picks an 80/20 split and three stocks for the satellite.

Now suppose the worst. One of the three stocks goes to zero. The portfolio loses $1,000 of $15,000, which is about 6.7%. That hurts, and the portfolio survives it. The fund holding $12,000 doesn’t care what happened to that one company.

Why the core comes first

The core’s result doesn’t depend on your stock picks being right. That’s the reason to buy it first.

Nobody knows in advance how good a beginner’s picks will be. That includes the beginner. Buying the core first puts most of the money on the market’s return from day one, whatever the picks do later, and if you bought stocks first and meant to add the fund “when there’s more money”, the portfolio would spend its early years resting on the part you know least about.

There’s a practical point as well. Stocks tempt you to trade. A fund you bought and left alone doesn’t, and having most of the money in something dull makes the whole portfolio easier to hold through a bad year.

Where the split stops working

The 80/20 figure is a choice. No interest in picking stocks? Then a satellite of zero is a perfectly good portfolio. If you want more of your own ideas in play, a bigger satellite is allowed, as long as you accept that your picks now carry more of the outcome.

For the longer question of how big any one stock should get, see how much of your portfolio one stock should be.

The split also drifts. A satellite stock that doubles makes the satellite bigger than you chose, and a single stock can grow into a large part of the whole without you buying another share. That drift is what the next lesson deals with, by putting a weight cap on each position before the first order goes in.