Portfolio Strategy: Don't be a Radical
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There are two ends to the argument on how best to construct a portfolio. Some people advise a portfolio of complete diversification. Many would have you believe that a well constructed portfolio should have at least 40 stocks with equal exposure to a variety of industries and countries. Others would say that as an investor trying to beat the market, you can't have a portfolio of more than 10 stocks. This way, you can keep track of each stock that you own and you have a concentrated enough bet in each one that each stock will make a real impact on your portfolio. There is definitely merit to both sides.
On the side of diversification, it's been shown by academic research over and over again that buying hundreds of stocks with low P/E or P/B ratios will consistently outperform the market over a large period of time. So it's pretty clear that a large portfolio can work. In fact, Benjamin Graham, the father of value investing himself, had a portfolio of over 100 stocks. On the other hand, this kind of diversification is condemned by many as hypocritical. You say you're trying to beat the market? Mix together 40 stocks and you already have more stocks than the Dow 30! You are the market, so how do you intend to beat it? Moreover, any real insight you put into your portfolio has pretty much been removed as the more diversified you are, the less non-market risk you're taking on. For the active investor, non-market risk is the best kind!
Of course that's exactly the bear case for a concentrated portfolio. Do your really want 10% of your portfolio to be in a bad investment if you make a small human error? If you diversify into a bunch of positions, you're more likely to succeed in the aggregate, right? Concentrated portfolio advocates say no! We work hard to research each stock we put into our portfolios, we want those stocks to have a real impact.
My opinion on the issue? It's a very gray matter, not nearly as black and white as everyone seems to believe. For example, Warren Buffett is famous for advocating a concentrated portfolio with big position sizes, as focused investing is the only real way to success. He is the best investor ever, so you would think he's probably right. However, if you look closely at the portfolio he is invested in, there are almost always positions in stocks that make up less than 10% or even 5% of the portfolio overall. So while Buffett is sometimes concentrated by up to 75% of his portfolio in one stock (GEICO), what he doesn't tell you is that he also diversifies with a bunch of smaller positions.
The only strict advice from Buffett's Partnership Letters that I think should be followed by investors is that no position should be smaller than 2.5% of the portfolio. This means that you should have at most 40 positions in your portfolio, plenty enough to fully diversify. This is because below 2.5%, each stock really starts to lose any material effect on your portfolio.
So...What's the Answer?
A little bit of both. When you find stocks that are generally undervalued, take smaller positions in the stocks. However, if you see a real catalyst or an extreme undervaluation, take a larger position to show your certainty in your portfolio's construction.
For example, Dell Inc. (NASDAQ: DELL) was recently hit hard due to weakening demand and supply chain errors. I personally believe Dell is worth around $16, so at $12 it might be worth creating a little position, no less than 2.5% but no more than 5% in Dell to show my opinions. The idea is that while Dell isn't likely to be a huge winner, I believe Dell is worth more than the cash I would be holding otherwise.
Similarly, Bank of America (NYSE: BAC) is selling below tangible book value. Many investors believe that it is extremely likely that every dollar invested in Bank of America will be worth $1.60 or more when Bank of America returns to tangible book value or higher. Instead of taking the risk of making a large position in a stock so tough for the average investor to analyze, you could take a small position in the stock. Eventually, you'll have a diversified group of small generally undervalued positions.
Meanwhile, Aflac Inc. (NYSE: AFL) is a stock that I am extremely confident about because I believe it has a unique business model and that it will rebound after Eurozone shock wears off. Being a dividend aristocrat with an extremely transparent management, Aflac is likely to have limited risk, and due to my high level of confidence, it might be worth a bigger position in my portfolio.
Diana Containerships (NASDAQ: DCIX) is also a high conviction pick of mine as it is selling below book value and raising its dividends consistently. With a 14% dividend yield, Diana Containerships may be worth a larger position.
Already you can see a portfolio forming with two major parts. There's the diversified generally undervalued stocks and the concentrated bets. Having a flexible portfolio like this should allow investors to make their portfolio allocations a true representation for their certainty on specific stocks and the market in general.
Don't be a Portfolio Strategy Radical. Diversification and Concentration both have their place in every portfolio so long as they're both used to effectively create the optimal portfolio for every investor.
shamapant owns shares of Aflac and Diana Containerships Inc. - Common Shares. The Motley Fool owns shares of Bank of America. Motley Fool newsletter services recommend Aflac. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.