How I invest, part 2: First the asset type, then the industry, then the company

If you missed it:
How I invest, part 1: Find the sweet spots

Investing is essentially deciding which alternatives to choose.

The highest level decision is how much to allocate to stocks, versus bonds and cash. 

The more you allocate to a diversified portfolio of stocks, the higher the long term return, assuming no panic selling or market timing:

Source: Stocks for the Long Run, by Jeremy Siegel

This type of long term return profile can be surprisingly hard to appreciate. We all understand the math. But at the same time we hear the standard advice to allocate a healthy portion of our portfolio away from stocks. A specific risk profile may argue for the need to include bonds. But in our first use of a "valuation tool," we'll learn how we can compare the expected return from stocks to that of bonds in a different way than is shown above. So when considering whether to accept lower returns in exchange for lower volatility, we can determine the relative value difference between investing in stocks or bonds.

Using "earnings yield" to compare the expected returns from stocks to that from bonds.

The forward PE ratio of the S&P 500, according to this nifty packet of information, was recently 17. We can invert that to get an "earnings yield" of 5.9%. Compare that to the 1.5% return available on 10 year treasury bonds to find that the current expected returns favor investments in stocks (over bonds) even more so than during the average returns experienced in the 200 years tracked in the image above.

Further evidence that the attractiveness of stocks, in comparison to bonds, is even more pronounced now than usual, can be seen in this chart, which plots the earnings and 10 year bond yields during the last 15 years or so.

Source

As is so often the case, the math makes it very questionable for a young investor to decide to invest in bonds in a portfolio that is designed to not be "touched" for many decades. Despite the commonly held belief that a "no bonds" portfolio is not recommended, I think that a well informed investor who is prepared to resist selling after the inevitable massive downward swings in stock prices can responsibly own no bonds. But I'm splitting hairs because even Vanguard, the market leader in responsibly providing financial services, suggests, by way of this 2057 target date fund, that a 25 year old hold 90% stocks in his portfolio.

Next consider the sectors and industries and their relative valuations

I focus on S&P 500 companies because I'm most confident it's there I'll find great information about high quality companies that will make great long term investments. The S&P 500 is a standard benchmark for judging long term performance because it includes 500 of the biggest US based companies, and there are many ultra low cost ways investors can "own" the index itself. It is very simple and straightforward to use that index as a benchmark for my long term performance.

The index consists of 10 "sectors," which as you see below range from ~5% to nearly ~25% of the entire index. The sectors and their relative weightings will not help decide which specific companies are good enough businesses selling at appropriate prices to make sound investments. But knowing the historical values of these large sectors, and understanding how to judge recent changes in value, can act as guideposts to make sure I don't make obvious mistakes.

For example, the "search for yield," a phrase financial commentators are using to describe the move by investors towards buying high dividend yielding stocks, has caused the index's two smallest components, Telecommunications and Utilities, to have the highest returns in the group during the last twelve months. (You'll notice it's always easiest for the smaller sectors or companies to have the highest percentage growth rates because of their smaller beginning bases.)

Telecom and Utilities have outperformed in the past year - Source

But during the past decade, these two sectors have performed the worst (in terms of return) in the group. That's of course the reason these are the smallest two sectors in the group.

Source

More research is needed for me to say this with certainty, but I would suspect that these two sectors, and on balance the companies within them, are currently traded at a much higher relative (to the other eight sectors) valuation than usual. *So if I were considering buying T or VZ, the only companies in these sectors that are currently in the universe of stocks I track, these "guideposts" would hopefully help me avoid the mistake of buying too high, or allocating too big a portion to these stocks.

*I don't own these stocks now. But I have and I may again.

Coming soon: 

How I invest, part 3: FB vs AAPL

Why both may be "good investments," but only one is in my strike zone

***Disclosure: I am not an investment professional and I don't write posts like these to suggest that readers buy specific stocks or do anything in particular with their specific financial plans. I don't know the specific details of readers' situations and needs, so they should take responsibility for their own financial decisions. I do currently own many of the stocks mentioned in this post.***