Tweaking Taleb to Build a Better Portfolio

This may be an improvement on 'The Black Swan' author's risk-averse allocation.
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Nassim Nicolas Taleb, author of "The Black Swan" and "Fooled by Randomness," believes investors take far more risk than they are equipped to handle. A year like 2008 might have been what he had in mind.

Taleb has addressed the evolution of portfolio construction. He has suggested a concept of allocating 90% of a portfolio to Treasury bills from around the world, and the remaining 10% to speculative investments with home-run potential.

The idea is that there is no risk in T-bills, so with the 90/10 mix, only 10% of the portfolio is at risk. Also, it would be difficult, for example, to buy 10 speculative stocks and have all of them go to zero at the same time, so, really, less that 10% of the portfolio is at risk of disappearing. If the speculative 10 doubled in a year, the entire portfolio would be up 10% plus the T-bill interest, totaling what a "normal equity portfolio" might earn in a typical year. The chance of an equity market return with so little invested speculatively is intriguing. Just because 10% would be invested speculatively does not mean there would be no homework done. Anyone pursuing this type of strategy would need to perform more due diligence, not less.

Accessing foreign treasuries had not been easy for U.S.-based investors until iShares and SPDR launched short-term foreign treasury ETFs. An investor wanting to put Taleb's idea into practice could put 45% into

SPDR Barclays 1-3 International Treasury ETF

(BWZ) - Get Report

for foreign exposure, 45% into

iShares Barclays 1-3 Year Treasury Bond Fund

(SHY) - Get Report

for domestic investments, and use the remaining 10% to buy a few well-researched ideas. (Instead of purchasing SHY, an investor could buy US T-bills and notes directly.)

I would tweak his concept slightly. I am a big believer in holding gold as an insurance policy against external shocks that adversely affect markets as well as inflation that could result from the recent rise of the U.S. money supply. Additionally, gold has done reasonably well during this bear market. Absolute return is also a category that has done well, depending on the product chosen, and is something I would want to include.

With that in mind, I propose: 40% in SHY, 40% in BWZ, 5% in

SPDR Gold Trust

(GLD) - Get Report

and 5% in

Rydex Managed Futures Fund

(RYMFX) - Get Report

. That leaves the remaining aggressive 10%. The size of the portfolio would determine how many stocks to pick, as buying 10 different companies with $1,000 per holding in a $100,000 account costs too much.

The best way to build that last 10% depends on a person's area of interests, but there are several themes I would consider.

The first is China. At its worst, that market was down 70% from its peak. In the past three months, it has quietly rallied 15%. There is a lot of concern about the near-term prospects for the country, but a 70% decline discounts much, if not all, of that concern. Additionally, China is going to become increasingly important in the world economic order.

Jiangsu Expressway

(JEXYY)

is an interesting way to go into China because it does not rely on exports and is not a financial stock. Jiangsu collects tolls, operates gas stations, food stops and hotels along the highway. Car buying in China is in a long-term uptrend, and trucks also use highways, of course, so when the economy starts to perform better, it stands to reason more trucks will be on the road.

Brazil was an excellent proxy for the economic expansion because of the resource-intensive building up and building out of infrastructure in many emerging countries. That buildup is far from over. The markets have priced in a slowdown of some magnitude as the Brazil Bovespa dropped 60% in five months last year. Since bottoming in October, that market has gone up 34%.

CVRD

(RIO) - Get Report

is a good proxy for this entire effect. The stock is well off its low, but at $14, it is still 67% below the high. If you think commodity demand comes back, Brazil and CVRD would seem to be obvious beneficiaries.

One theme that might not live up to its billing is alternative energy, specifically wind and solar. While it seems to me that this is clearly the time to build the infrastructure needed to make widespread use possible, the recent drop in oil prices seems to have removed the urgency to spend on this now. It is common to extrapolate the most recent trend to continue. If that persists, what was an important catalyst for alternative energy is removed, albeit misguidedly.

This is mostly an academic exercise, but it teaches about allocating risk and volatility within a portfolio. It is likely that most of the return achieved will come from a relatively small portion of the holdings. This is an important dynamic to understand as you construct and then manage your portfolio.

At the time of publication, GLD, RYMFX, JEXYY and RIO were client or personal holdings, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback;

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