Investment portfolio: Do s and Don’t s
I have taken a position that excessive diversification creates a suboptimal portfolio. Beyond a certain level, further diversification does not lessen any more risk, but it does hurt performance of the portfolio. My respected colleague, Ken Faulkenberry echoes the same thoughts when he talks about over diversification and its effect on portfolio returns.
Some readers have questioned my advice on creating a focused investment portfolio. so I want to make a few things clear:
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- You should not buy stocks if you do not want to spend time to understand the business and research the stock – mutual funds are appropriate in this situation. And if you do not want to spend time to research and understand the funds and their investment philosophy, than by all means buy an index fund. But if you do want to invest in individual stocks, you need to be prepared to spend time to understand the business. This is true even if you use a stock picking service like mine (highly recommended!)
- Assuming you are prepared to do the due diligence required for picking stocks, than realize that in addition to initial research, you will need to spend regular time keeping up with the businesses you own and adjusting your investment portfolio regularly
- The question is, how many stocks can you effectively manage and track – 5? 100?
- Diversification is good and advised – to a certain point. I personally believe that 10-15 stocks, representing a diverse set of industries and sectors, provide all the benefits of diversification that one needs and is manageable by an individual investor. Beyond this number, you will not be able to devote proper time to research your stocks and you will make bad decisions.
- A portfolio of 20 stocks is a focused portfolio, but it is also a diversified portfolio if sufficient care is taken in picking stocks from across the spectrum of sectors and industries.
There is Risk, and Than There is Risk
Whenever a statement is made that diversification reduces risk, you need to ask the question – which risk? All diversification does is to bring in assets that may be uncorrelated to each other, making the portfolio as a whole less volatile. When one stock zigs, another might zag. It, however, also makes your portfolio more correlated to the market, so when the whole market goes down, your portfolio goes down as well. In the long run, if you buy into the premise that the market always goes up, than this is not a problem. But than, why not just buy an index fund?
The whole idea behind reducing volatility is to cap the downside of the portfolio. Unfortunately, it also caps the upside, since excellent performance in one stock will be dampened by not so good performance of other stocks. And if the portfolio is filled with stocks picked at random, than there is little hope for out performing the overall market. Diversification is not a magic bullet. It will not create good performance out of a portfolio that is made up of bad stocks with little to recommend them besides a hot tip, hope and prayer.
Now let me state something that should be obvious, but it isn’t to most investors
“If your goal is to match the performance of the overall market in your own portfolio, you should not be buying stocks. Period. You should just own a S&P 500 index fund. It is less work, and less hassle and you are more or less guaranteed to track the market”
The only reason you would want to own individual stocks is to do better than the market averages.
And the only way to do better than average is to pick stocks that are better than average. Every stock that you decide to include in your portfolio should have a reason and analysis that supports that pick. If you can’t make a case for a stock to out perform the market, you don’t buy it. Simple. If you follow good investing principles and can only find 1 stock that meets your criteria – buy that 1 stock and let it be the only stock in your portfolio. But also keep in mind the following as you build your portfolio:
- Try not to put more than 10% of your portfolio in any 1 stock. So in our extreme 1 stock portfolio example above, 90% or more of your portfolio will be in cash. If a 20 stock portfolio is more your thing, you want your average holding to be in the 5% of the portfolio range.
- When you own more than 1 stock in the same industry, try not to put more than 15% of your portfolio in any single industry. You may choose to be a little flexible here depending on the situation. For example, if you know an industry inside out and are convinced that there are some strong catalysts in the future, you may want to have a higher exposure.
- It is okay to be in cash at times when you are short of ideas. It is not okay to buy stocks that you have not researched just because you are itching to put your cash to use.
- If one of your stocks runs up and exceeds the 10% allocation guideline, do not sell the stock to bring the allocation back to the suggested. Only sell the stock if a case can be made for the sale. In short, make buy or sell decisions based on the merits of that particular stock or if other better opportunities present themselves. Re-balancing for the sake of re-balancing is a mindless act. Once you sell a stock, than you can decide how to use the cash so it brings your portfolio back in alignment with your allocation goals.
I personally like to buy stocks at a great discount to its intrinsic value. This gives me good downside risk protection and does not unnecessarily hedge out my upside.
What do you think?