Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.

This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.

Edition 72

The financial industry is never short on ideas about how investors might outperform the market. While some of these ideas are reasonable, others appear to exist purely to keep the brochure printers running - a noble contribution to the disappearance of trees.

Among these enduring proposals is the core-satellite approach to portfolio construction. This is often positioned (sometimes a little optimistically) as a way to enhance returns, while keeping a portfolio anchored to something stable. In its simplest form, the approach involves building a diversified ‘core’ allocation and then surrounding it with smaller, more tactical positions known as ‘satellites’.

It’s also worth flagging that outperformance is only one of the outcomes associated with the structure. It also gives investors a controlled way to express a view without letting that view dominate the entire portfolio.

Over the years, I’ve used this framework myself with varying degrees of success, so today we’re taking a closer look at what the strategy is, how it tends to play out in practice, and what some of the considerations around pursuing it are.

Getting to the core of it

I’ve been investing for almost a decade now. Though my days of plotting candlestick charts on dubious crypto apps are far behind, it’s never felt harder to be an investor. Before anyone starts drafting a rebuttal, I acknowledge that markets have become more accessible, fees have come down and information is everywhere. But that’s precisely the problem for most young investors.

I’ve never been subjected to as much investment marketing as I am now. Often these mass marketing efforts prey on our worst behavioural tendencies and can result in a portfolio that resembles a collection of incoherent ideas. The core-satellite structure is one way to counter this.

The core allocation forms a foundation for the portfolio with investments in this category intended to be broad and diversified with the expectation of steady long‑term returns. Because the core carries most of the allocation, it also carries the most influence over how the portfolio behaves. It is intentionally dull in the same way that lodging an honest tax return is.

Around that core foundation sit the satellites. These are smaller, more targeted positions that reflect specific views or interests. This could be anything from picking a thematic fund, sector tilt, or even individual stocks you think might have meaningful upside. Because satellites tend to be narrower and more volatile, they usually comprise only a small portion of the portfolio. While there’s no strict rule, conventional wisdom keeps satellites in the 5-20% range.

The approach is frequently described as a blend of passive and active investing. The core leans on the benefits of low-cost exposure to broad markets, while the satellites give you room to speculate, tilt or try to outperform the market. Whether that blend is logical is an entirely separate debate in itself.

The math behind the appeal

The argument for carving out a small portion of a portfolio to pursue higher‑risk opportunities is fairly straightforward. Theoretically, if a small satellite allocation meaningfully outperforms, it can substantially increase your overall long-term returns. And on the flip side, if your satellite performs poorly, the damage is somewhat limited due to the smaller position. To illustrate this point let’s run through an example.

Say an investor has a $100,000 portfolio and allocates 90% to a core holding which returns 7% annually and 10% to a satellite investment which successfully returns 15% annually. Over a 20 year horizon, the portfolio would grow to roughly $512,000, whilst the baseline scenario without a satellite would finish around $387,000.

The successful satellite investment in this case lifts the final return around 32%. Flipping the script, if the satellite position performed poorly and had a flat return over 20 years, the portfolio ends on $348,000, roughly 10% below the baseline with no satellite. The upside in this example is rather meaningful, while the downside is somewhat contained.

Of course, this is a highly specific scenario with fixed returns, no volatility, no sequencing effects and no behavioural interference. It is far from a realistic depiction of how markets or investors behave. But is does demonstrate why the optionality can be appealing. A small amount of well‑placed risk (at least in theory) can enhance returns without jeopardising long‑term stability. Though it’s not without challenges.

My own experience

I’ve had my own share of satellite mishaps, so perhaps I am somewhat biased. Barring any semblance of beating the market, my satellite exposure came with a stark reminder that the freedom choice gives you comes with a very real gamble – you actually have to pick something that outperforms.

As obvious as it may seem, one of the biggest challenges is selecting the right investment. To put it plainly, most investors are facing dismal odds when attempting to outperform the market by picking individual holdings. Thematic funds don’t have a particularly impressive long-term record either.

Doing diligent research can help, but it doesn’t eliminate the risk of backing the wrong idea at the wrong time, or even the right idea at the wrong time. Ultimately, it is a gamble on a series of assumptions, coupled with a bit of luck.

A few other considerations

Beyond the practical issues, I think there is cognitive dissonance baked into the whole idea. The core-satellite model is often pitched as a blend of passive investing with an active side‑pocket for speculation. But if you genuinely believe in the premise that underpins passive investing, which is that most people don’t beat the market, then carving out a portion of your portfolio specifically to not be passive is somewhat contradictory.

I tend to embark on a refined‑sugar cleanse every now and then, perhaps a symptom of reaching the latter half of my twenties. And yet, I often fall victim to the catering leftovers in the office. It’s the same pattern of acknowledging something is unproductive, then doing it anyway. The human condition is nuanced enough to explain it, but we can’t pretend the behaviour is perfectly aligned with a coherent philosophy.

Even if you understand the maths and accept the intellectual dissonance of blending passive discipline with active bets, the behavioural side of core-satellite is where things tend to unravel. A common problem is overconfidence bias, that is, overestimating your knowledge, skills and ability to predict market movements.

Imagine two years into your core-satellite portfolio, your satellite allocation has delivered astronomical returns while your core has plodded along, relatively unimpressive. Maybe you should allocate more to the satellite. Maybe the satellite should be the core. Maybe you’ve cracked the code. It is quite clear to see how limiting speculative exposure to a small position can be derailed.

The labels of ‘core’ and ‘satellite’ don’t really mean anything beyond the boundary you artificially manufacture and as an investor, it is your responsibility to uphold this boundary.

On the flip side, poor performance can trigger a different set of behaviours. Instead of expanding the satellite, investors may abandon ship at the first sign of poor performance creating trading costs.

I think all of this really sits on top of acknowledging a broader affliction – we are not passive creatures, even when we invest ‘passively’. The core-satellite model assumes you can hold two conflicting ideas at once. The markets are efficient enough to justify a passive core, but inefficient enough to justify you trying to exploit it through active satellites. It is a delicate balance and most investors lean too far in one direction or the other.

Concluding thoughts

Contrary to the title of this article, the core-satellite model is in no way a guarantee of outperformance. It is an approach that many investors find intuitive and appealing.

I’m aware this likely reads as an overly pessimistic take to the whole thing. However, I think there is some value to be found in the ability to impose a structure to decision making. A thoughtful core-satellite approach demands we articulate our objectives, define the role of each investment and ultimately maintain a higher level of discipline. Implementing these measures are a universal net positive to any investment strategy.

The most important decision you make won’t be whether to adopt this structure, but whether your underlying investment beliefs are coherent and durable.

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