Designing the Common Stock Portion of Your Retirement Portfolio: Concentrated or Diversified Part 3
Designing the common stock portion of your retirement portfolio is very challenging. For starters, there is no absolutely perfect or even best way to design a stock portfolio. However, there are many effective strategies that have produced successful long-term results. The key to success is to find and implement the strategy that best fits your own unique goals, objectives, needs, and most importantly - risk tolerances.
There are many aspects associated with designing a common stock portfolio that need to be considered. The number of individual companies to include in your portfolio is a big one. In addition to the number of companies, how much weight you should put in each one. Should they be equally weighted? In other words, should you put the exact same percentage of your portfolio in each company? Or, does it make more sense to overweight some and underweight others? Moreover, should you own stocks from every sector or just the ones you like the best?
These are just a few of the important questions that investors must grapple with when designing a common stock portfolio. But most importantly, and I repeat myself, there is no absolute or perfect strategy for constructing a stock portfolio that fits every individual investor. On the other hand, there are important considerations that every individual investor would be well advised to contemplate. Ultimately, it comes down to designing a stock portfolio that suits you.
Therefore, my objective with this article is to provide some food for thought and common stock portfolio design ideas that I hope can help individual investors make better choices that fit and meet their own needs. I am a big proponent of applying logic and common sense to the investing process. Consequently, rather than just giving specific portfolio construction strategies, I also intend to offer some logical ways to look at common stock portfolio construction.
The Universal Principle: Start With a Plan
I believe that there is only one universal principle about constructing a common stock portfolio that universally applies to every investor. Prior to building any portfolio, common stock or otherwise, it is imperative that every investor starts by developing a comprehensive and detailed plan. Importantly, it’s not only imperative to have a plan, it’s even more vital to be disciplined about following it.
This is commonly referred to as an investment policy statement ((IPS)). However, an IPS generally goes beyond defining investment goals and objectives, it also takes into consideration risk tolerance, liquidity requirements and asset allocation. However, for the purposes of this specific article, I am simply referring to a well thought-out plan design for the common stock portion of an overall portfolio. Therefore, my discussion will be limited to investment goals, objectives and risk tolerances.
Logically then, the first step in creating your investment plan is to clearly identify and determine your specific investment goals and needs. For example, if your primary objective is growth or total return, your focus might be best placed on a portfolio combination of growth stocks and/or above-average growing dividend growth stocks. In contrast, if your primary objective is current income, your focus might be best placed on a portfolio combination of blue-chip dividend paying stalwarts and/or high-yield stocks. I covered these categories extensively in part 1 and part 2 of this series.
Of course, there are many variations of what the most appropriate mix of stocks might be. Therefore, depending on your needs and risk tolerances, the mix of appropriate stocks are only limited by each investor’s imagination coupled with their needs. Once again, there is no perfectly right or wrong answer, except to design a portfolio that is capable of meeting your goals, and one that you are comfortable enough with to stay the course.
How Many Stocks Should My Portfolio Hold?
The question of how many stocks a portfolio should contain has been widely discussed, and even hotly debated. Some of the greatest investors that ever walked the planet have shared their views and opinions, and there have been numerous academic studies conducted as well. However, there really is no consensus, and many of the differing views are supported by compelling and logical arguments. Interestingly, the arguments of many renowned fundamental investors versus academics that have conducted studies are not that far apart.
Therefore, instead of supporting any specific number of holdings, I have chosen to offer some practical considerations that individual investors might think about. On the other hand, I will also share some of the views and opinions of others who have studied the subject of how many stocks to own.
The Simple and Basic Mathematics Behind How Many Stocks to Own
At the risk of being accused of stating the obvious, I believe it’s important to consider and have a clear perspective of the basic mathematics behind how many stocks you own. In my opinion, this is important because it relates to the investor’s risk tolerance. Additionally, it also relates to the potential rate of return a portfolio can achieve. So let’s look at some basic numbers.
For starters, let’s assume that you are constructing an equal weighted portfolio. This simply means placing the same amount of your investment in each selection. Therefore, the number of stocks you place in a portfolio represents the percentage of your portfolio it comprises. The basic math is simple. If you hold 5 stocks, they each comprise 20% of your portfolio. If you hold 10 stocks, they each comprise 10%. If you hold 20 stocks, they each represent 5%. If you hold 25 stocks, they each represent 4%, and so on.
The fewer stocks you own, the greater your exposure to good or to bad things happening in the future to each individual stock. For example, all things being equal, if you only hold 5 stocks, and 1 of them falls 50% in value, your overall portfolio would drop by 10%. In contrast, if you hold 25 stocks, and 1 of them falls 50% in value, your overall portfolio would only drop 2%. This represents the risk aspect discussed previously. The lower your tolerance for risk, the more stocks you should hold - and vice versa. Therefore, although this is pretty basic, I believe it’s an important yet simple mathematical perspective to hold clearly in the back of your mind at all times.
Concentrated Or Diversified: What Do The Experts Suggest?
Let’s start with what academic studies have concluded. Frankly, I was surprised to discover that there are academic studies that support concentrated stock portfolios. For example, according to a MorningStar classroom report found here, academic professors Frank Riley and Keith Brown reported in their book “Investment Analysis And Portfolio Management” that about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.
To paraphrase the report, this suggests that by owning only 18 stocks you will get the same return as investing in a passive market index. The report also suggested that if you own more than 18 stocks, you are simply increasing your workload without receiving much benefit. The MorningStar report went on to suggest that there is also a practical risk to being too diversified. The report implies that by owning more than 18 stocks it becomes nearly impossible to know your companies well enough.
I suggest that the reader follows the above link and also read some of the other chapters on constructing a common stock portfolio. Frankly, this short course does a better job of discussing ways to build a common stock portfolio, and more succinctly that I can in this article.
As an investor with a strong orientation to valuation, I have made it a point to study the behaviors of the most renowned value investors that have ever lived. However, I am certainly not alone in that endeavor. There is an excellent website on value investing founded by fellow Seeking Alpha author Vishal Khandelwal that studies and reports on the behaviors and practices of prominent value investors and value investing in general found here.
In a post titled “How Many Stocks Should You Own?” He offered a summary of the opinions of several legendary investors that I personally admire greatly as follows:
“Just to sum up, here is what the legends have advised on how many stocks you should own in your portfolio…
- Ben Graham – 10 to 30…with each company being large, prominent and conservatively financed.
- John Keynes – 2 to 3…companies which one thinks one knows something about and in the management of which one thoroughly believes.
- Warren Buffett – 5 to 10…if you are a know-something investor, able to understand business economics and to find sensibly-priced companies that possess important long-term competitive advantages.
- Seth Klarman – 10 to 15…better off knowing a lot about a few investments than knowing only a little about each of a great many holdings.”
Additionally, one of my favorite value investors of all time, Phil Fisher, had very strong opinions on how many stocks investors should hold. The following quote taken from the book “The Warren Buffett Way” by Robert G. Hagstrom nicely summarizes Phil Fisher’s views:
“Phil Fisher taught Buffett the benefits of focusing on just a few investments. He believed that it was a mistake to teach investors that putting their eggs in several baskets reduces risk. The danger in purchasing too many stocks, he felt, is that it becomes impossible to watch all the eggs in all the baskets. In his view, buying shares in a company without taking the time to develop a thorough understanding of the business was far more risky than having limited diversification.”
To summarize this section on how many stocks to put in a portfolio, I suggest that less is more. For anyone managing their own stock portfolio, a comprehensive understanding of each business you own is worth more than the marginal benefit of being more broadly diversified. On the other hand, if you are very sensitive to risk, you might need to own more stocks just for the peace of mind it brings.
For example, an equally weighted portfolio of 30 stocks means that each holding only represents a little over 3% of your total portfolio. Therefore, no calamitous disaster on one holding will affect your overall portfolio very much. Nevertheless, a portfolio of only 10 stocks might be too concentrated for many investors. Consequently, I believe an equally weighted portfolio of 20 to 25 stocks offers a good compromise for most investors. However, this is not an ironclad rule and many investors might only be comfortable holding more than 25 or 30 stocks. At the end of the day, it’s really a matter of investor preference and risk tolerance.
Should You Equal Weight or Overweight Portfolio Holdings?
The answer to the question regarding how many stocks to hold in a portfolio discussed above related primarily to an equal weighted portfolio of stocks. However, there is also the question of overweighting versus equal weighting that can also affect the optimum number of stocks to hold in a portfolio. This is a question that many investors who self-manage their own stock portfolios have as evidenced by the following comment by a reader in part 2 of this series:
“Nice Summary Chuck..
I have a question which you might have an opinion on re: building a portfolio.
Is it better to equal dollar weight your stock selection, OR could you allocate the capital better by overweighting predicted higher annual ROR vs lower predicted annual ROR. I guess this would slant the portfolio a bit to perhaps more faster growing companies..”
There are advantages and disadvantages to both equal weighting of a stock portfolio and overweighting your holdings. To my way of thinking, the best course of action, as always, relates to the individual investor’s own goals and also to their risk tolerances. Additionally, each individual investor’s general knowledge about investing in stocks coupled with the amount of time they have available for research are additional important factors.
To complicate matters more, there are numerous approaches and strategies that can be implemented with overweighting stocks in your portfolio. Unfortunately, I will only be able to address a few of the more prominent ones. However, I think it’s important that the reader understands that there are many approaches towards overweighting a stock portfolio, but not necessarily a best one.
The 60/40, 70/30, 80/20 and 90/10 Approach
One conceptual approach that I have personally successfully implemented over my career for investors in the accumulation phase prior to retirement is one I call the 60/40, 70/30, 80/20 and 90/10 Approach. This common stock portfolio design concept primarily dealt with 2 broad categories of equally weighted common stocks - blue-chip dividend paying stalwarts and growth-oriented stocks.
The central idea is to build a solid foundation of conservative blue chips supplemented by riskier growth stocks. If both your risk tolerances and total return needs were high, you might put 60% of your money in conservative blue chips and 40% in more aggressive growth stocks. In contrast, if your risk tolerances were low but you still needed some additional growth, you might put 90% of your money in blue chips and only 10% in growth. Of course, each additional blend would be determined by the needs and risk tolerances of each individual investor. In essence, the more growth you choose, the higher your total return expectation. However, the more growth you choose, the more risk you must be willing to assume.
Variations of this approach could also be applied to already retired investors in need of income. In this situation you would blend your mix based on the yield characteristics of your individual selections. This could be blue-chip dividend paying stalwarts such as Johnson & Johnson or Procter & Gamble, mixed in with the appropriate mix of higher-yielding REITs and/or MLPs.
The key is that your common stock portfolio should be custom-designed to meet your own goals, needs and risk tolerances. There is no one-size-fits-all, and each individual investor is unique and different. However, there are common sense tried-and-true principles that can be, and should be, commonly applied. Always starting with a well-defined plan is a good example.
The More Aggressive Concentrated/Diversified Approach
As the reader can imagine, there are numerous variations and common stock blending strategies that can be implemented than just those discussed above. Another one that I have successfully implemented is what I call the aggressive concentrated/diversified approach. An example of this strategy might be to place 50% of your money into your top 5 selections (10% of your total in each). The remaining 50% of your money could be heavily diversified by putting 2% increments into 25 additional companies, or even 1% increments into 50 additional companies.
With this strategy, you are very selective with your top 5 holdings in the first place, and in the second place you research, watch and monitor them closely and comprehensively. To be clear, your top 5 holdings are intensely researched and focused upon. With the remaining, for example 25 or 50, you allow the principle of broader diversification to take care of them. The idea here is to swing at the fences with half of your money and look for singles and doubles with the other half.
Although this is a risky portfolio construction strategy, it can pay off enormously in the long run. The 5 stocks you are overweight in could be aggressive growth stocks capable of producing the 10, 20 or 30 baggers that Peter Lynch talked about in his book “One Up On Wall Street.” The remaining stocks could be comprised of more conservative blue-chip dividend payers. If you want to be really aggressive with a total return objective, every stock could be aggressive growth. Once again, the variations are endless. It all comes down to your own goals and risk tolerances.
As an interesting aside, Peter Lynch utilized a variation of this strategy, but at a different scale, when he ran the Fidelity Magellan fund. In his book “One Up On Wall Street” in the chapter “Designing A Portfolio” he had this to say:
“Some people ascribe my success to my having specialized in growth stocks. But that’s only partly accurate. I never put more than 30% to 40% of my funds assets in the growth stocks. The rest I spread out among the other categories described in this book. Normally I keep about 10% to 20% or so in the stalwarts, another 10% to 20% or so in the cyclicals, and the rest in turnarounds. Although I own 1400 stocks in all, half of my funds assets are invested in 100 stocks, and two thirds in 200 stocks. 1% of the money is spread out among 500 secondary opportunities I monitoring periodically, with the possibility of turning in later.”
After reading the above, the reader should consider that Peter Lynch had billions of dollars to deal with and invest, as well as a large staff of associates to assist him. Obviously, for us average investors out there; our resources are much more limited. Nevertheless, the underlying principles that Peter Lynch was articulating appropriately apply, only the scale of our resources is different.
The Importance of Sound Valuation on the Buy Side
One of the most important universal principles that I’ve previously discussed is only investing in stocks at sound valuation. It doesn’t matter whether you’re buying growth stocks, blue-chip stalwarts or any of the other categories discussed in this series - investing at sound valuation matters. You can equally weight your portfolios, or use an overweight strategy similar to what I presented above, and sound valuation matters.
There are many ways to control risk; proper diversification is certainly one of them. But so is being prudent when purchasing stocks, any stock. So from my point of view, the best portfolio construction advice that I can offer is to focus on value at all times. And although this is critical on the buy side, it also importantly applies to the sell side. In other words, no matter how you’ve constructed it, once your portfolio is constructed, focusing on valuation is a tried-and-true portfolio management technique.
Summary and Conclusions
There is no consensus on the best way to construct a common stock portfolio. On the other hand, there are many practical methods that have proven successful. Perhaps most importantly of all, is that each investor should “know thyself.” The odds are very low that your portfolio can produce the results you want and need if it is not constructed in a way that is compatible with your own psyche and goals. The key to any well-designed portfolio strategy lies in your ability to effectively implement it over time. If your holdings make you uncomfortable, no matter how conservative or aggressive they may be, you can end up being your portfolio’s own worst enemy.
Additionally, I believe that portfolios should be goal specific oriented. Instead of worrying about beating the market or generating the highest total returns, I believe it makes more sense to build a portfolio that meets your needs. If you need maximum income - invest for that. If growth is your goal - invest for that. Every common stock portfolio has a job to do, and therefore, it should be designed with a clear and specific focus on achieving those goals.
Importantly, in order to achieve your goals, you must start out with a well thought-out plan. Constructing an appropriate common stock portfolio should never be about throwing a bunch of mud on the wall and hoping that some of it sticks. To me it makes much more sense to invest in the types of common stocks that are aligned with your objectives and risk tolerances.
Most great investors recommend knowing as much about the companies you own as is humanly possible. I contend that the same advice relates to your portfolio as well. Each investor should have a clear perspective and understanding of what their portfolios are designed to do, and whether each of the individual parts is capable of getting the job done.
Finally, if you are desirous of self-managing your own portfolios, there is no substitute conducting comprehensive research and due diligence. This requires the willingness and ability to allocate the proper time and attention to your portfolios. This principle supports concentration over excessive diversification. And in the long run, it also pays to have the proper tools at your disposal. In today’s Internet age, many tools are available for free. Other tools such as the F.A.S.T. Graphs™ fundamentals analyzer software tool that I use require a modest fee. Nevertheless, the point is to develop a plan, acquire the tools to execute the plan, and be as precise as possible in what stocks you select and whether their attributes are compatible with your needs.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.