****Constructing a Portfolio

Now that you have learned to analyse companies and pick stocks, it is time to focus on putting groups of stocks together to construct your stock portfolio.

No one answer is right for everyone when it comes to portfolio construction. It is more art than science. And perhaps that's why many believe portfolio management may be the difference that separates a great investor from an average mutual fund manager.

Famed international stock-picker John Templeton has often said that he's right about his stock picks only about 60% of the time. Nevertheless, he has accumulated one of the best track records in the business. That's because great managers have a tendency to have more money invested in their big winners and less in their losers.

The Fat-Pitch Approach

You should hold relatively few great companies, purchased at a large margin of safety, and that you shouldn't be afraid to hold cash when you can't find good stocks to buy. But why?

Most investors will discover only a few good ideas in any given year - maybe five or six, sometimes a few more. Investors who hold more than 20 stocks at a time are often buying shares of companies they don't know much about, and then diversifying away the risk by holding lots of different names. It is tough to stray very far from the average return when you hold that many stocks, unless you have wacky weightings like 10% of your portfolio in one stock and 2% in each of the other 45.

About 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks. If you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.

If you want to obtain a higher return than the markets, you increase your chances by being less diversified. At the same time, you also increase your risk.

If you own more than 18 stocks, you will have achieved almost full diversification, but now you will just have to keep track of more stocks in your portfolio for not much marginal benefit.

When you own too many companies, it becomes nearly impossible to know your companies really well. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor. Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.

Non-Market Risk and a Concentrated Portfolio

Interestingly, holding a concentrated portfolio is not as risky as one may think. Just holding two stocks instead of one eliminates 46% of your unsystematic risk. Using a twist on the 80/20 rule of thumb, holding only eight stocks will eliminate about 81% of your diversifiable risk.

Unsystematic Risk and the Number of Stocks in a Portfolio

Number of Stocks   Non-Market Risk Eliminated (%)
1======== 0%
2 ========46%
4 ========72%
8 ========81%
16======= 93%
32======= 96%
500====== 99%
9,000==== 100%

What about range of returns?

Joel Greenblatt in his book You Can Be a Stock Market Genius explains that during one period that he examined,

• the average return of the stock market was about 10% and
• statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between negative 8% and positive 28% about two-thirds of the time.
• That means that one-third of the time, the returns fell outside this 36-point range.

Greenblatt noted that if your portfolio is limited to only :

• 5 stocks, the expected return remains 10%, but your one-year range expands to between negative 11% and positive 31% about two-thirds of the time.
• 8 stocks, the range is between negative 10% and positive 30%.

In other words, it takes fewer stocks to diversify a portfolio than one might intuitively think.

Portfolio Weighting

In addition to knowing how many stocks to own in your portfolio and which stocks to buy, the percentage of your portfolio occupied by each stock is just as important.   Unfortunately, the science and academics behind this important topic are scarce, and therefore, portfolio weighting is, again, more art than science.

The great money managers have a knack for having a great percentage of their money in stocks that do well and a lesser amount in their bad picks.  So how do they do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick.  If you have a lot of confidence in the long-term outlook and the valuation of a stock, then it should be weighted more heavily than a stock you may be taking a flier on.

If a stock has

• a 10% weighting in your portfolio, then a 20% change in its price will move your overall portfolio 2%.
• a 3% weighting, a 20% change has only a 0.6% effect on your portfolio.

Weight your portfolio wisely.  Don't be afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about.  And, of course, don't go off the deep end by having, for example, 50% of your portfolio in a single stock.



Portfolio Turnover

If you follow the fat-pitch method, you won't trade very often.  Wide-moat companies selling at a discount are rare, so when you find one, you should pounce.  Over the years, a wide-moat company will generate returns on capital higher than its cost of capital, creating value for shareholders.  This shareholder value translates into a higher stock price over time.

If you sell after making a small profit, you might not get another chance to buy the stock, or a similar high-quality stock, for a long time.  For this reason, it's irrational to quickly move in and out of wide-moat stocks and incur capital gains taxes and transaction costs.  Your results, after taxes and trading expenses, likely won't be any better and may be worse.  That's why many of the great long-term investors display low turnover in their portfolios.  They've learned to let their winners run and to think like owners, not traders.



Circle of Competence and Sector Concentration

If you are investing within your circle of competence, then your stock selections will gravitate toward certain sectors and investment styles. 

Maybe you:

• work in the medical field and thus are familiar with and own a number of pharmaceutical and biotechnology stocks, or,
• you've been educated in the Warren Buffett school of investing and cling to entrenched, easy-to-understand businesses such as Coca-Cola and Wrigley.

Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses.  Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio.  For instance, you probably wouldn't want all of your investments to be in unattractive areas such as the airline or auto industry.



Adding Mututal Funds to a Stock Portfolio

In-the-know investors buy stocks.  Those less-in-the-know, or those who choose to know less, own mutual funds. 

But investing doesn't have to be a choice between investing directly in stocks or indirectly through mutual funds.  Investors can - and many should - do both.  The trick is determining how your portfolio can benefit most from each type of investment.  Figuring out your appropriate stock/fund mix is up to you.

Begin by looking for gaps in your portfolio and circle of competence. 

• Do you have any foreign exposure?
• Do your assets cluster in particualr sectors or style-box positions?

Consider investing in mutual funds to gain exposure to countries and sectors that your portfolio currently lacks.

Some funds invest in micro-caps, others invest around the globe, still others focus on markets, such as real estate.  Stock investors who turn over some of their dollars to an expert in these areas gain exposure to new opportunities without having to learn a whole new set of analytical skills.

Ultimately, your choice depends on your circle of competence and comfort level.  While many may feel comfortable with picking their own international stocks, others may prefer to own an international equity fund.



Our Objective

Modern Portfolio Theory has been built on the assumption that you can't beat the stock market. If you can't beat the market porfolio, then the best you can do is to match the market's performance. Therefore, academic theory revolves around how to build the most efficient portfolio to match the market.

We have taken a different approach.  Our objective is to outperform the market.  Therefore, we believe that our odds increase by holding (not actively trading) relatively concentrated portfolios of between 12 and 20 great companies purchased with a margin of safety.  The circle of competence will be unique to every person; therefore, your stock portfolio will naturally have sector, style, and country biases.  If lacking in any area, such as international stocks, a good mutual fund can be used to balance your overall portfolio.