The idea of “core and explore” investing is that you commit the bulk of your portfolio to a sensible “core” strategy, and use a small percentage to “explore” some of your own stock picks. Much has been written about the merits of this investing approach, but my thinking differs from what I’ve read before.
As a starting point, it’s important to admit that for the vast majority of investors, the explore part of the portfolio will underperform a core index strategy over the long term. I won’t defend this assertion here, but if you reject it, then you won’t agree with much else I say. However, it’s not automatically true that core and explore is a bad idea just because the explore part of the portfolio is likely to underperform.
One possible benefit of core and explore is that it allows an investor to scratch the itch to make stock picks with a small amount of money in the explore pot instead of making much bigger bets with the entire portfolio. In effect, allowing some exploring may be the only way for some investors to stick with a boring but solid plan with the bulk of their portfolios.
Of course, adopting core and explore may harm some investors as well. It’s inevitable that an investor will make a couple of good (or lucky) picks in the smaller explore part of the portfolio. This could embolden the investor to begin making stock picks with the entire portfolio.
In the end, whether or not core and explore is a good idea for a particular investor depends on that investor’s psychology. Given the choice between being 100% indexed and using core and explore, how would a particular investor fare with each? If the investor would execute the index strategy without fail, then it is very likely the better strategy. However, if the investor would constantly tinker with allocation percentages with pure indexing, but exploring with a small amount of money would prevent such tinkering, then core and explore is better.
So far, I’ve only considered the investor’s expected returns as a measure of how to invest. But there are other considerations as well. For example, some people find it fun to pick stocks. Few really do any meaningful analysis, but it can be fun to channel your overconfidence and think you can just know that a company will do well. It can also be fun to talk about your picks with other people. This fun has some value. The problem is that it also has a cost in likely long-term portfolio underperformance.
Few people are able to assess the expected underperformance of their stock-picking. One method is to assess the drag due to taking on uncompensated risk based on some model of stock returns. The math isn’t overly difficult but extremely few investors will estimate the cost and decide whether the fun justifies the cost. A complicating factor here is that most stock-pickers really do think they can pick above-average stocks. If this is really true, then there is no reason to stop stock picking. But we know that it isn’t true for the vast majority of investors.
Some may think that if only 10% of a portfolio is allocated for exploring, then the most the investor can lose is 10%. This depends on what the investor does after losing some money on bad stock picks. Will the investor just live with an explore part of the portfolio that is only 5%, or will he or she replenish it back to 10%? With replenishing, the total losses over decades can be much more than just 10%.
In the end, those who choose core and explore investing will do so for emotional reasons and will not know in advance how much money it is likely to cost them compared to pure index investing. But at least being 90% invested with a core plan beats being 0% invested with a core plan.