Discovering the Satellite – What are the Satellites in a Core-Satellite strategy?

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Discovering the Satellite – What are the Satellites in a Core-Satellite strategy?

Here at Financial Autonomy we follow the framework set out in the Financial Autonomy book. One of the pathways in that framework is stocks and within that section I explore the Core-Satellite strategy in some detail. It’s a strategy we use a lot with clients. In this post we’re going to dig in a bit to the satellite component of this strategy. What constitutes a satellite, why have satellites at all, and how much should you allocate to a satellite?

I should mention too that an audiobook version of the Financial Autonomy book has recently been released. You can get that in all the normal spots and I’ve done the narration, so if you find my voice tolerable on the podcast hopefully you likewise find it tolerable in the book.

This week’s post was inspired by a meeting I had on Monday with a Financial Autonomy Programme client and podcast listener. Hello Claire if you’re listening. One of the things for us to review was her share portfolio. She had created it herself but was a bit disappointed in how it was going and felt a little lost. When we went through the portfolio it became obvious that the idea of the Core-Satellite approach hadn’t registered for her. The portfolio comprised lots of small speculative holdings and had a weak to almost non-existent core.

What is the Core?

In this post I want to focus on the satellite element but before we jump into that let’s just briefly cover what the core is all about. The core in a Core-Satellite strategy is the boring part of your portfolio that provides broad market performance. History tells us that we can have a high level of confidence that if we invest our money broadly across Australian and international share markets and leave it alone for long enough we will get an attractive outcome, certainly one that is superior to leaving our savings in the bank. The challenge though can be capturing that market return. If you choose a portfolio of 20 individual stocks for example, then perhaps you miss a couple of big growth stocks or themes, and as a result don’t get the returns that the broad market delivered. An example of this in recent times could be a portfolio of purely top 20 Australian listed companies – BHP, the banks, Telstra etc. Such a portfolio would have no technology sector exposure, resulting in you missing out on the strongest growth area in the past several years.

The idea with the core then is to use broadly diversified holdings, typically funds of some sort, to give you that market coverage.

The thinking then with the Core-Satellite strategy is that having a strong core ensures your portfolio will deliver something like the overall market. And again, from history we know that getting a return in line with the broad market will be a good outcome over time.

It’s reasonable to ask then why have anything other than the core? Indeed it’s not necessary to have anything other than the core, however plenty of people, myself included, want to have some interesting, and perhaps more speculative investments, in the hope that we can pick a winner or two and boost our performance.

Okay so hopefully you’ve got the concept of the core clear in your head. Now let’s get into the meat of today’s episode, the satellites. The key considerations here are why have satellites, which we sort of touched on just now but will discuss a bit more. What satellites are, in other words some examples. And how many satellites are appropriate in a portfolio.

Why have Satellites?

Why have satellites in your portfolio? As already mentioned it’s typically to scratch a personal itch. If you’re listening to this podcast then clearly you have an interest in investments and perhaps financial markets and so hopefully you’ll appreciate that it’s an interesting space. Picking individual investments, is likely to be a much better hobby then betting on the horses or the football on the weekends. Most speculative investments, even if they don’t work out as planned, won’t end up being completely worthless. And who knows, you might pick the next Amazon. The satellite portion of your portfolio is where you can use your intellect and insight.

Another great advantage of the Core-Satellite approach is that it controls your level of risk. By limiting your risky investments to only being in the satellites, and holding the bulk of your wealth in the core holdings, you guard against overconfidence and excessive speculation. You can get your investment market adrenaline hit without risking you or your family’s long term future.

Sometimes too with our Financial Autonomy Programme clients we look after the core portfolio for them and they manage the satellite portion. This can work really well for someone who’s keen to have a bit of a dabble. They can be as aggressive as they like with their satellite holdings, in the knowledge that there’s a safe and stable core in the background ensuring their long-term financial security.

How much in the Satellites?

Okay, so we’ve covered why you might have a satellite component in your portfolio, the next question is how much should be in the satellite portion?

The general default is to allocate 20% to satellites, and certainly 40% of your portfolio in the satellite portion should be considered the upper limit. Any more than this and the returns in the core portion won’t be enough to offset any satellite catastrophes.

So let’s say you’re at about 20% of your portfolio in satellite investments. How much to each satellite? This depends a lot on the size of your portfolio. If your investment portfolio was for instance $100,000, and therefore you had $20,000 available for satellites, I would work on four satellites at $5,000 each. If your satellites are too small, transaction costs will likely eat into performance, and even if they perform well, a small investment of say $500 is never going to grow enough to have a meaningful impact on your life. In this example then someone with a $100,000 portfolio could hold 4 satellites. If you had a larger portfolio you may well be able to expand this to have a few more. But again, maintain discipline here. Too many small satellites simply dilutes the impact of any winners. A scatter-gun approach is not what we’re after here. Remember the core component of your portfolio has broad market exposure. The idea of the satellites is to have targeted investments that are more risky and perhaps more speculative in nature.

Satellite examples

And what sort of investments might these satellites be? Most typically they are individual stocks, usually mid or small cap companies where you have some sort of insight or belief and want to back the company directly. But satellites could be a lot broader than this. Cryptocurrency investments are a popular satellite that we’re seeing more and more. Satellites might include unusual ETF’s, for instance an E-sports ETF or something in biotech. Satellites could include precious metals, or even collectables like watches, cars, or guitars.

Hopefully you can see given this array of possibilities for the satellite portion of your portfolio why running your investment strategy this way makes investing interesting, whilst also controlling for risk. You wouldn’t want to have half your total investment wealth in collectible guitars for instance, but if it was 5% of your wealth, and you understood the guitar market, perhaps that’s a great idea, and the research involved will probably be a wonderful outlet.

I mentioned at the beginning that this post was inspired by my meeting with Claire. You will recall her portfolio consisted of numerous small speculative holdings and almost no broad core holdings. My suggestion to her was to pick the five speculative stocks that she most believes in, retain these, and then consolidate all the other holdings into two or three core investments. Broad funds covering local and international markets that will lock in market performance. In this way she’d end up with a simpler portfolio that would produce roughly market returns, with the potential for some outperformance if one of her speculative investments was to hit the jackpot.

 

I hope this week’s discussion on the Core-Satellite strategy helps you. If you’d like one on one Financial Planning advice be sure to check out the Advice page on the Financial Autonomy website to learn all about our Financial Autonomy Program.

 

Other things you might find helpful

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Pick up your copy of the Financial Autonomy book here where I take you through the proven Financial Autonomy framework, developed through 20 years of helping Australians gain choice in life.

Here’s another post on the Core/Satellite strategy: How to use the Core-Satellite Strategy

 

 

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