Holding Individual DJIA 30 Stocks For PP Security

[TripleB]

With scandals such as MF Global, one concern many investors have is avoid fraud. CraigR recommends brokerage diversification and holding securities with as few layers inbetween you and the security as possible, i.e. hold direct bonds or gold coins rather than an ETF.

When it comes to the stock portion of the PP it's cost ineffective for most investors to avoid ETFs and Mutual Funds because transaction expenses of buying that many individual stocks is high. I'm proposing a possible solution to provide some protection at low costs.

The DJIA is 30 large cap stocks on the US Stock Exchange. These 30 stocks represent about 70% or so of the TSM from last I recall. They have 90% or greater correlation with the TSM. The Dow 30 stocks rarely change.

I propose that one takes 25% to 50% of their equity position and place it into the 30 individual stocks of the DJIA in appropriate levels to match the index. Then, place the rest of your equities into TSM index funds or if you really want to match TSM overall, add in the VG Extended Market index fund in a small level to create an overall equity position that nearly matches TSM.

When it's time to rebalance, you do it from the ETF/Mutual Fund. The individual stocks are "Deep Storage" which effectively have a 0% ER on a long enough time line (or an actual 0% ER if you have free trades).

The benefits here are that you reduce one layer from your investment holdings as you hold the stocks directly. SPIC insurance will likely cover you in the event of brokerage failure.

It would be interesting to set this up with Vanguard directly holding your VG Mutual Funds since they are reasonably trustworthy. Then use a second brokerage to hold the individual stocks. Possibly Wells Fargo since they offer a bunch of free trades if you have $50k or so in assets with them.

One downside will be difficulty in tax-loss harvesting. Thus, if you have a large IRA/401k and keep stocks in there anyway, then this would work better for you.

[craigr]

This would be a lot of work and potential for stuff to go wrong. I'd just hold stock index funds from a reputable provider like Vanguard and call it a day.

[KevinW]

Yeah, I think this would work if it were executed diligently. However it's quite possible that someone would screw it up due to oversight or being tempted into making timing decisions. IMO that is a greater risk than the counterparty risk involved in a transparent company like Vanguard. If you follow HB's advice and diversify the stock among several reputable funds then the counterparty risk is even less.

[AgAuMoney]

So would you reproduce the weighting of each holding in the DJIA?

And while the list of 30 companies changes infrequently, the weighting can change any time, and in practice does change every time there is a significant share event at any of the 30 companies (e.g. a split, acquisition, spin off, etc).  Would you rebalance to maintain the weighting?

And would you really buy all 30 companies in their specified proportion, even if you really hated one or more of them (BAC, CVX, XOM, DD are frequently hated) or thought they would not do well (BAC or HPQ seem pretty bad lately)?

I don't think its a reasonable plan to rebalance to/from a fund over the long term.  Maintaining 30 positions plus your funds is going to cost more because you will have more transactions.  Trying to track an index will add to your transactions.

I agree with the previous post on the relative risks...  The risk of holding a fund vs. you doing individual stocks seems like the fund would be safer.

But hey, if you are really dedicated to stock picking then go for it.  I am a dividend growth investor myself.  I have a dozen or so individual stocks plus VBK and still have a chunk of VTI in my PP I'm trying to rebalance out of when opportunity arises.  Did great overall last year, and the stock portion is good so far this year.

[smurff]

You would have to keep up with splits, reverse splits, spinoffs, regular dividends, special dividends, delistings, the works, every quarter (at least) for all 30 companies.

Some people have the time to do all of this--they are called ETFs and mutual funds (plus a handful of individuals). I suspect, however that most individuals, unless they are in the industry or have portfolio management as a hobby, would screw it up.

[stone]

I really wonder whether the index is as magical as it is made out to be. I've got this lurking suspicion that say ten diverse decent individual stocks each kept at 2.5% of the PP (with say 1.5% to 3.5% rebalancing bands)  might actually work better than having a cap weighted index at 25% of the PP.

[TripleB]

Does the weighting really change over time?

If I hold the 30 stocks in proper weighting today, then won't any splits simply change my personal weighting along with the index weighting? Since it's a cap weighted index, as shares of Apple rise, then it's weighting in the index rises, and since I'm already holding shares of Apple, my personal index should match the DJIA at all times, shouldn't it?

I agree that if I had to go in there and buy more shares of one or two, and sell shares of one or two every year, that would be annoying. However if I can just buy, hold and forget, then it would work.

Essentially, my overall equity position would be identical to TSM through the use of VG Extended Market Index. When I buy new equity shares or sell equity shares to rebalance, then I do it completely through TSM index funds. Thus, I'd never have to touch the individual DJIA stocks.

[shoestring]

Wouldn't the denominator of that faux Dow Index always be the whole you would weigh the rest of the shares to?

The weighting unquestionably changes as the components slide up and down relative to each other, but when you weigh everything against the total Dow market cap (your denominator) it seems like an increase or decrease in any given stock won't mess up the proportion, it will just raise or lower the total value of the portfolio.

I don't see how the research would be hard either, find a Dow Jones index ETF that uses a methodology you trust and pull its literature, the proportion work is done for you.

One problem I can see is that with 30 stocks, as opposed to a few thousand, the likelihood of shenanigans like major company destroying fraud is much higher even if the overall historical correlation is high between DJIA and TSM.  Or said another way, one company's fortunes are going to matter far more to you.  I think that's contrary to the idea of the PP, that taken as a whole it "smooths" things out as well as anything can be expected to.

IBM for example is around 10% of the DJIA at the moment I think, so if this was your entire stock slice a complete meltdown of IBM would destroy 2.5% of the entire portfolio.  With a TSM fund it'd be what, a 0.375% loss?  You could therefore have a year where an index fund using PP would have a gain and one using these 30 individual stocks could have a loss much more easily I think.  You could argue the same for the reverse, I get that, but it's the same "problem".  It seems like you're in for a rougher ride in the short term even if historically it's about the same.

The other is that while it seems pretty rare a company should come off/go onto this index, maybe it's not as rare as we think.  I'd find out how often this has actually happened.  Even if market forces keep everything in line so long as you don't monkey with your original shares bought in proper proportion, a change in the lineup would modify all of the weightings as the total index cap would suddenly shift and it seems like you'd have to do a lot of transactions.  When you've got 30 individual stocks, are you really going to put in all those orders at once, indifferently, regardless of tax consequences, etc?  Maybe you'd see it coming, but that's the same problem, if you "know" a company is coming off the index how are you going to react etc.?

That's just me, but I'd be too tempted to monkey with things.

I certainly wouldn't do this myself but I can't say what's wrong with it in theory beyond the idea that my perception is that it's simpler and less work to just use a TSM fund and be happy.

[stone]

Triple B, surely what you say would only be true if the number of shares in circulation remained fairly constant for each company. Let's imagine you hold 0.000001% of Apple or whatever. They then use employee stock options to increase the number of shares in circulation by 20%. In order to now still have 0.000001% of Apple, you would need to buy more Apple shares. Otherwise you would end up owning a reduced ratio of Apple in comparison to a less diluted stock. With share buybacks you would have the same issue but in the opposite direction.

[Gosso]

The Dow Industrial Index is very simple.  It holds one share of each of the 30 companies.  If there is a 2:1 stock split, then you will have two shares and will have to sell one of them.  They maintain a "correction factor" that keeps the Dow price from jumping whenever there is a stock split.

Most people call the Dow an obsolete index, since it's % weighting is based on the price of the stocks. IBM has the highest stock price, and therefore has the highest weighting in the index.  In some ways I really like the Dow...it has a certain charm and simplicity, plus it has an interesting history behind it.

I seriously considered creating my own Canadian Dow Index for the stock portion of the PP, but decided against once I realized that this would require a significant amount of maintenance, energy, and discipline.  As mentioned by the posts above, there is the high risk that I would be dragged back into the market timing, chart reading, stress increasing bullcrap, which I am trying to get myself away from.

[TripleB]

One problem I can see is that with 30 stocks, as opposed to a few thousand, the likelihood of shenanigans like major company destroying fraud is much higher even if the overall historical correlation is high between DJIA and TSM.  Or said another way, one company's fortunes are going to matter far more to you.  I think that's contrary to the idea of the PP, that taken as a whole it "smooths" things out as well as anything can be expected to.

I'd be weighting my personal DJIA index the same as TSM. Offhand I believe it's around 70% of TSM is the SP500 and of the SP500 around 80% to 90% of that is the 30 DJIA stocks. Thus, I can easily structure my holdings such that my weighting of individual stocks would match that of TSM. So if shenanigans occur in one of the DJIA 30 stocks, then it was going to affect someone holding TSM in an identical fashion.

Just because TSM holds 5,000 stocks doesn't mean you are much more diversified than DJIA because those 30 stocks make up a substantial percentage of a TSM fund.

VG offers an Extended Market Index which holds small and mid cap stocks. Thus, with a mixture of the DJIA 30 stocks plus the Extended Market Index in an appropriate ratio of about 4:1, I could essentially "recreate" TSM myself, while holding the individual DJIA 30 stocks personally.

I do need to better understand how the stock splitting and share dilution affects market cap weighting because I don't want to have to do a bunch of re-balancings each year on my 30 stocks.

[stone]

Isn't there a small industry devoted to front running the cap weighted index funds whenever those funds have to adjust due to new shares being created/bought back? I thought that they creamed off more than the overt TER of typical index funds.

[Bob]

If one was to go this route, would you consider a combination of DIA (DJ30 ETF) and VXF (Vanguard Extended Market ETF)?  Any thoughts or ideas on this combination rather than holding all 30 DJ stocks?

[AgAuMoney]

I really wonder whether the index is as magical as it is made out to be. I've got this lurking suspicion that say ten diverse decent individual stocks each kept at 2.5% of the PP (with say 1.5% to 3.5% rebalancing bands)  might actually work better than having a cap weighted index at 25% of the PP.

I agree.  I don't think the index is magical at all.  The only thing the index has is fame.  Funds following the index are worse.

Looking at the DJIA, the S&P 500 or even the TSM (e.g. VTI) I found the huge majority of the holdings are a handful of large cap stocks, just as has been noted in this thread.  The DJIA is a totally arbitrary committee decision with the constituents weighted by price, the S&P 500 is mostly cap-based but the allocation between sectors is a totally arbitrary committee decision.  The various TSM are cap based, but the funds which follow them usually hold no more than 2x-4x the stocks of an S&P 500 fund, usually only 10%-30% of the fund value is different from an S&P 500 fund, and the choice of what to include or not is an arbitrary decision using various derivatives to simulate total market exposure (typically not even S&P500 funds hold all 500 stocks).  So if you know 50 large-cap stocks, you probably know 50% of the TSM fund.  Another 50 stocks will get you another 30%-40%.

I know some of those stocks from personal experience or extensive research.  I know them well enough I do not want to own them by owning the index.  I may be wrong, but over the past 10 years since I started doing my own large-cap research and investing (dividend-growth style) I've tromped the index (even tho the index holds Apple, while I do not).  Small-cap are a different story as the universe is so large.  So I need to own a small-cap index if I want any significant small-cap exposure.

My PP account is a 401(k) rollover IRA.  To avoid long-term sitting in cash rather than stock, after the rollover I started with VTI and about 2% (of the 25%) each to 12 individual stock positions.  After more research I decided I didn't like VTI so I'm moving to VBK (to reduce my large-cap weighting).  VBK will eventually be 50% to 30% and individual stocks (10 to 15 tickers) will be 50% to 70% of the total stock allocation.  Instead of shifting immediately I'm using required rebalance transactions to move toward the long-term allocation in order to minimize costs.

My plan is to keep each of the stock positions roughly equal, and the total stock allocation within the 20-30% of PP bounds.  So I rebalance in/out of the stock allocation to meet PP needs, and rebalance within the stock allocation when the needed shift is 1) significant to the position size and 2) costs of making the shift are insignificant to the size of the shift.

Including the cash my PP is up over 18% in the past 12 months.  (Of course essentially all the returns are from the other 75%, so the actual "investment return" is much greater.)

[smurff]

The other is that while it seems pretty rare a company should come off/go onto this index, maybe it's not as rare as we think.  I'd find out how often this has actually happened.  Even if market forces keep everything in line so long as you don't monkey with your original shares bought in proper proportion, a change in the lineup would modify all of the weightings as the total index cap would suddenly shift and it seems like you'd have to do a lot of transactions.  When you've got 30 individual stocks, are you really going to put in all those orders at once, indifferently, regardless of tax consequences, etc?  Maybe you'd see it coming, but that's the same problem, if you "know" a company is coming off the index how are you going to react etc.?

In the past five years (2007-2012), five stocks have been replaced in the index:  Bank of America, Chevron, Cisco Systems, Kraft Foods, and Travelers, all in 2008 and 2009.  That's some 17 percent of the index, which would not constitute rare occurrences, and is a lot for something expected to be stable.

During the decade of the 1990s, ten stocks have been replaced:  Wal Mart, Disney, AT & T (was named SBC Communications), Catepillar, Hewlett Packard, Home Depot, Intel, Johnson and Johnson, JP Morgan, and Microsoft.   Four in 1999, three in 1997, three in 1991.  That's a full one-third of the index in a decade, and again, not rare, and a lot for something expected to be stable.

[melveyr]

I think keeping the PP simple is best practice.

If you like the idea of owning individual stocks, perhaps making this a VP is a good idea. You could also engage directly in various large cap DRIP programs. This could satisfy speculative urges, while promoting low turnover (moving money would be kind of a pain), and help diversify against counter-party risk. because if the company went bankrupt, the shares would be worthless anyways.

[TripleB]

There's a lot of really good points here. I've always heard the magical number for MPT was 30 stocks. I'd bet that if we extended that graph out to 5,000 stocks of TSM, we'd see that there's virtually no more benefit to hold more than 30 stocks, and as the graph shows, 15 stocks could be the sweet cost-adjusted spot to spend the least amount of expense on trading to get the maximum diversification value.

As far as whether my 15 stocks beat or lose to the index, as was stated above, "there's nothing magical about the index." So what if my 15 stocks underperform the index by 2% or overperform by 2%?

Here's an interesting extrapolation of my original idea. Suppose I wanted to be 100% in US Stocks for my PP Equity Position. I have $400k in my PP, thus $100k is stocks.

I put $50k of stocks into TSM Index Fund. I then take the other $50k and buy about $3k of each of 15 large cap stocks from the DJIA, with at least one from each of the 10 sectors.

My goal is NEVER to sell those $50k of individual stocks, because then I incur trading expenses. Instead, new stock money, and rebalanced stock money goes into/out of the TSM Index Fund.

When it's time to rebalance internally, i.e. suppose my TSM becomes 70% of my stock holdings and individual stocks are only 30%. Then I buy a few more individual stocks, of maybe $4k each this time, assuming my previous 15 stocks all went up.

Now I'm holding 18 individual stocks of about $4k each. Rather than trying to rebalance the 15 stocks I initially picked with new money, I simply buy a whole new stock every time I get another $4k or so to put in. Over time, I gradually increase my diversification a bit more.

I simply "don't care" how my individual stock selection performs relative to the index because it will be close enough. I get the benefit of holding individual stocks which gives me a slight edge over a mutual fund that has some minor counterparty risk involved since I don't know for sure they are holding the underlying securities.

To be completely honest, the biggest thing preventing me from doing this is that everytime I buy a new individual stock in my VP from Vanguard, they mail me a 50 page document from that company. And then I get crazy voting documents in the mail every so often. I really hate mail, and it's the biggest reason why I don't do much individual stock trading.

[stone]

Triple B, to my mind, the potential benefit of holding individual stocks would be the volatility capture opportunities. A volatile stock that didn't pay much dividend might provide tremendous opportunities for harvesting that volatility by rebalancing (selling high and buying low). If you think about it, a company that doesn't pay a dividend and survives for thirty years can be thought of as a zero coupon amortizing bond. As such it is totally pointless to own it without rebalancing BUT could provide a lot of profit if rebalanced.
My guess is that it is ideal to keep a fixed ratio between each holding (eg keep each of ten stocks at 2.5% of the PP). Perhaps every five years or so decide whether any stock needs to be replaced with some other stock. What I don't know is whether the tax implications of such an approach would be very bad.

[melveyr]

Triple B, to my mind, the potential benefit of holding individual stocks would be the volatility capture opportunities. A volatile stock that didn't pay much dividend might provide tremendous opportunities for harvesting that volatility by rebalancing (selling high and buying low). If you think about it, a company that doesn't pay a dividend and survives for thirty years can be thought of as a zero coupon amortizing bond. As such it is totally pointless to own it without rebalancing BUT could provide a lot of profit if rebalanced.
My guess is that it is ideal to keep a fixed ratio between each holding (eg keep each of ten stocks at 2.5% of the PP). Perhaps every five years or so decide whether any stock needs to be replaced with some other stock. What I don't know is whether the tax implications of such an approach would be very bad.

Strictly adhering to re-balancing bands is a double edge sword though.

What if one of the companies shares went to $0 over the course of ten years? Following re-balancing bands would mean that your overall portfolio would approach $0 as well. You would continually be shoveling money into the stock, a black hole of capital.

[stone]

I totally agree that you would need to be vigilant not to own a dying company. If you just chose ten stocks carefully and kept abreast of what they were up to, do you think it is that likely that one of them would die? I also think it would be important to have some rule about not topping up any given stock more than once a year or whatever. I thought it might make sense to every five years or so, choose the ten sensible stocks afresh without being swayed by what was held up to that point.

Triple B, to my mind, the potential benefit of holding individual stocks would be the volatility capture opportunities. A volatile stock that didn't pay much dividend might provide tremendous opportunities for harvesting that volatility by rebalancing (selling high and buying low). If you think about it, a company that doesn't pay a dividend and survives for thirty years can be thought of as a zero coupon amortizing bond. As such it is totally pointless to own it without rebalancing BUT could provide a lot of profit if rebalanced.
My guess is that it is ideal to keep a fixed ratio between each holding (eg keep each of ten stocks at 2.5% of the PP). Perhaps every five years or so decide whether any stock needs to be replaced with some other stock. What I don't know is whether the tax implications of such an approach would be very bad.

Strictly adhering to re-balancing bands is a double edge sword though.

What if one of the companies shares went to $0 over the course of ten years? Following re-balancing bands would mean that your overall portfolio would approach $0 as well. You would continually be shoveling money into the stock, a black hole of capital.

[AgAuMoney]

I think keeping the PP simple is best practice.

If you like the idea of owning individual stocks, perhaps making this a VP is a good idea. You could also engage directly in various large cap DRIP programs. This could satisfy speculative urges, while promoting low turnover (moving money would be kind of a pain), and help diversify against counter-party risk. because if the company went bankrupt, the shares would be worthless anyways.

I think simple is not best.  I think individual stocks are better.  That's why I do it.  I think simple is a compromise for people that want simple for whatever reason.

And yes I have a VP with more and different stocks, but I disagree that individual stocks belong only in the VP.

Also you are wrong about company sponsored DRiPs.  They do not eliminate counter-party risk but only change it.  Your DRiP stocks must be held at the custodian selected by the company, typically ComputerShare, Wells Fargo, BoNY Mellon (now part of ComputerShare), or some others.  So you have the risk of problems with the custodian, not just the company issuing shares.  The only difference between this and holding stocks in a cash brokerage account is the agent says that the stocks are registered in your name and in the brokerage account you are listed by the brokerage as the beneficial owner.

And if you are concerned about counter-party risk, realize that using a fund adds a layer of counter-party risk that individual stocks do not have.

[shoestring]

I'd be weighting my personal DJIA index the same as TSM. Offhand I believe it's around 70% of TSM is the SP500 and of the SP500 around 80% to 90% of that is the 30 DJIA stocks. Thus, I can easily structure my holdings such that my weighting of individual stocks would match that of TSM. So if shenanigans occur in one of the DJIA 30 stocks, then it was going to affect someone holding TSM in an identical fashion.

I'm still unclear how this could work.  Let's got with DJIA is 70% of the TSM.

Let's pretend the TSM is only 10 equally weighted stocks and the DJIA is 7 of those equally weighted stocks.  The stocks that are in TSM that are not in DJIA will be labeled TSM, with the understanding the whole market includes the DJIA stocks as well.

DJIA 1 thru 7 - 10% each - 70% total
TSM 1 thru 3 - 10% each - 30% total

TSM Portfolio total - 100%

If you just throw out the TSM only stocks, you're left with:

DJIA 1 thru 7 - 10% each - 70% total

Since it doesn't add up to the whole, my the question is, do you increase each of those stocks to something like 14% each so they are proportional with each other, despite the fact they're not not proportional with the TSM, or what are you using for the extra 30%?

Just because TSM holds 5,000 stocks doesn't mean you are much more diversified than DJIA because those 30 stocks make up a substantial percentage of a TSM fund.

In terms of historical return and numbers and all that I absolutely agree.  But I like owning thousands versus dozens for some extremely unlikely contingencies.

[melveyr]

I think keeping the PP simple is best practice.

If you like the idea of owning individual stocks, perhaps making this a VP is a good idea. You could also engage directly in various large cap DRIP programs. This could satisfy speculative urges, while promoting low turnover (moving money would be kind of a pain), and help diversify against counter-party risk. because if the company went bankrupt, the shares would be worthless anyways.

I think simple is not best.  I think individual stocks are better.  That's why I do it.  I think simple is a compromise for people that want simple for whatever reason.

Do you re balance between stocks? Or do you treat the whole 25% equity portion as a sandbox?

And yes I have a VP with more and different stocks, but I disagree that individual stocks belong only in the VP.

Also you are wrong about company sponsored DRiPs.  They do not eliminate counter-party risk but only change it.  Your DRiP stocks must be held at the custodian selected by the company, typically ComputerShare, Wells Fargo, BoNY Mellon (now part of ComputerShare), or some others.  So you have the risk of problems with the custodian, not just the company issuing shares.  The only difference between this and holding stocks in a cash brokerage account is the agent says that the stocks are registered in your name and in the brokerage account you are listed by the brokerage as the beneficial owner.

And if you are concerned about counter-party risk, realize that using a fund adds a layer of counter-party risk that individual stocks do not have.

Do you re-balance between the stocks?

Or do you just treat the 25% portion as a sandbox for your picks?

[AgAuMoney]

Do you re-balance between the stocks?

Or do you just treat the 25% portion as a sandbox for your picks?

In general I try to keep each stock position roughly equal in value.

In practice I do have about 1/3 of the 25% (so about 8-9% of the portfolio) in VBK (small-cap growth) which is equivalent to several stock positions.  For rebalancing all I have had to do is add to a couple of lagging stock positions and take out of VBK into cash.

Currently my individual stocks range from about 1.5% to 2% of the portfolio.  Only one is 1.5% and only one is 2%.  Most are more than 1.7% and less than 1.9%.  VBK is getting a bit too large, and the overall stock portion is currently at 28%.  If the current directions keep going I'll be taking some more off VBK and dividing it between treasuries and cash...