The Two-Bucket Approach: Balancing Consistency and Opportunity in Your Investment Portfolio

Unpacking my peronal investing approach and strategy

Investing can be a daunting task, especially for new investors, but having a well-defined strategy can help you navigate the complexities of the market and increase your chances of achieving long-term investing returns at ultimately achieving your financial goals. In this post I will unpack my personal investing strategy that I like to call the Two-Bucket Approach." This approach combines the benefits of passive investing with the potential for outperformance through active stock selection. In this article, we will explore the key principles and advantages of this investment strategy. The approach as the title suggests following two separate investment strategies that can be viewed in silos or in separate buckets. 

The Beta Bucket - Tracking the Total Stock Market

The first bucket in the Two-Bucket Approach is what I like to call the Beta Bucket. Its purpose is to establish a core position in your portfolio by investing in a low-cost exchange-traded fund (ETF) that tracks the performance of the total stock market. This ETF aims to replicate the returns of the global stock market which can be measured using an index like the MSCI World Index. 

By investing in the Beta Bucket, you gain exposure to the overall stock market and capture its long-term growth potential. During the period from 1978 to 2023 the MSCI World Index has returned an average annual return of 10.78% (Source: curvo.eu). ETFs are known for their low expense ratios, which means that you can minimize costs and keep more of your returns instead of paying over excessive fees to a fund manager. Moreover, ETFs provide diversification across a wide range of companies, sectors, and asset classes, which helps to reduce the risk associated with individual stock selection.

This passive approach aims to provide consistent returns over the long run and forms the foundation of the Two-Bucket Approach. By allocating a significant portion of your portfolio to the Beta Bucket, you ensure that you capture the overall market performance while also benefiting from lower costs and reduced risk. Another advantage of the Beta Bucket is that you can purchase an ETF in your Tax-Free Savings Account and contribute a maximum of R500 000 which can compound tax free. 

Bucket 2: The Alpha Bucket - Active Stock Selection

The second bucket in the Two-Bucket Approach is called the Alpha Bucket. Unlike the Beta Bucket, which focuses on passive investing, the Alpha Bucket involves picking individual shares in a concentrated portfolio. This active strategy allows investors to express their personal investing style and potentially outperform the broader market. 

My personal investing style in my Alpha Bucket has strong tilt towards small-cap value stocks trading at a large discount to my estimated intrinsic value. I typically look for companies with strong balance balances and little to no debt that are highly cash generative and are returning surplus cash to investors in the form of share buybacks and dividends. The intention of this post is however not to steer you in a certain direction of how you should fill your Alpha Bucket as this is a personal investing decision and should be tailored towards your own style and your competitive advantage. If you have specialised knowledge of a certain sector or industry, then perhaps your Alpha Bucket should be centred around that sector / industry. 

In the Alpha Bucket, investors have the freedom to conduct thorough research, identify undervalued companies, and invest in stocks with the potential for significant growth. As already mentioned, this approach enables you to capitalize on your knowledge, expertise, and insights into specific industries or companies.

However, it's important to note that investing in individual stocks carries higher risks compared to diversified ETF investments. The performance of individual stocks can be influenced by various factors such as company-specific news, industry trends, or macroeconomic conditions. Therefore, careful stock selection, diversification within the Alpha Bucket, and ongoing monitoring are crucial for managing risk. However, that being said it is important not to be overly diversified in your Alpha Bucket as you already have this global exposure to hundreds of companies through your Beta Bucket ETFS. Holding too many stocks in your Alpha Bucket will defeat the purpose of having a concentrated portfolio that seeks to outperform the market. I would personally recommend between 8 to 15 stocks in your Alpha Bucket.

The Synergy of the Two Buckets

The Two-Bucket Approach combines the stability and consistency of passive investing in the Beta Bucket with the potential for higher returns through active stock selection in the Alpha Bucket. This strategy provides a balanced approach to investing, leveraging the benefits of both approaches.

The Beta Bucket provides a solid foundation for your portfolio by capturing the overall market returns and minimizing costs. It serves as a long-term, low-maintenance investment that can help you weather market fluctuations and generate consistent returns over time. It also gives you access to tax-free investment returns through a product like a tax-free savings account. 

The Alpha Bucket, on the other hand, offers the opportunity to generate alpha, which refers to returns that exceed the market's average. By investing in a concentrated portfolio of individual stocks aligned with your investing style and insights, you have the potential to outperform the market and enhance your overall returns. The Alpha Bucket also gives you the freedom to research and hold individual stocks guilt-free knowing you have the good foundation of your Beta Bucket. The percentage split between your Beta Bucket and Alpha Bucket ultimately comes down to your own risk tolerance and experience and expertise picking individual stocks. If you are new to the market, I would not recommend your Alpha Bucket comprising more than 20% of your total allocation. However, if you have a proven track record picking individual stocks and experience in fundamental analysis then perhaps 50% 50% between your Beta Bucket and Alpha Bucket would be suitable.

Conclusion

The Two-Bucket Approach offers an investment strategy that combines the benefits of passive investing in the Beta Bucket with the potential for outperformance through active stock selection in the Alpha Bucket. 

It is important to remember that every investment strategy carries risks, and it's essential to align your approach with your financial goals, risk tolerance, and time horizon. Consider consulting with a financial advisor who can help tailor your investing approach to your specific needs and guide you toward making informed investment decisions.

The information provided in this article is for informational purposes only and should not be considered financial or investment advice. Always do your own research and consult with a qualified financial advisor before making any investment decisions.