Portfolio Building Part 2

As the strategy to follow, there are as many portfolio’s possible as people alive. In this sense, investing is an art, not a science. Your personal portfolio should reflect who you are as a whole, it should contemplate from your risk profile to your experience and knowledge. In this article, I’ll guide you through the major inputs and in the next one through how to ‘Screen’ for stocks and how to then research them.

How many stocks should I include?

 Most investors believe that the more stocks you have, the more diversified you are and hence, the better. Far from true. Diversification comes not from the number of stocks you own but from the range of businesses you are exposed to. If you have a thousand stocks and all of them belong to the same sector/industry, the most likely thing is that you are extremely under diversified. If a supply/demand shock occurs in this sector, your whole portfolio will suffer.

 Another point to take into account is an investor’s capability to keep up with the businesses he bought. After some threshold, it becomes physically impossible to follow so many companies, this would mean to read their results/news, industry forecasts, etc.

 Now to the question, I’ll base this answer in several investors like Pat Dorsey, Chris Mayer, Warren Buffet. It is believed that, in general lines, between 10-20 stocks it’s the sweet spot. This allows an investor to properly diversify while he’s still able to keep up correctly with them all. As I said, it is an art though, Peter Lynch held 1000+ stocks at some point in his fund and still delivered a great track record.

How much to allocate in each position?

In Part 1, you learned how to detect at which point of the risk/return curve you belong. From that, you can infer the category allocation (balanced was 50 50 for ex) and split among the holdings that fit each category.

Regarding the subject, some warnings.

1.      Concentration: As a rule of thumb, don’t allocate more than 10% (arbitrary) to a single stock. Why? Graham writes:

“Because the future is uncertain, an investor can’t put his eggs into one basket.”

“Almost no small fortune has been made through concentration and not many big fortunes were kept this way.”

2.      Volatility: Beware that your portfolio’s volatility does not exceed the permitted by your Risk Profile.

How to know your portfolio’s volatility?

 If you are correctly positioned in terms of your risk profile, you’ll not suffer from price movements. To get to this point, your positions, overall, have to be aligned with it. There’s a technical way to measure your portfolio’s volatility, which is basically a ‘Weighted Average’.

This would imply getting the individual ‘beta’ of every stock (easily found in yahoo finance) and multiplying every stock’s beta by the percentage they represent in the portfolio. Then, add these results. The Portfolio’s beta you’ll obtain will imply how much volatility does your portfolio have in relation to the market (the market has a beta of 1).

The second option would come from knowing each company’s financials and thesis, and arbitrarily determining whether they are conservative or risky in your opinion. In this case, you ignore price fluctuations and you merely focus on business performance.

Conclusion

Building a portfolio is difficult, but it must be done right.  The next issue will be about how to screen (look for) stocks, how to research them and how to buy.

Two EXTRA Important releases:

I’ll be posting research done on a company and an example of what a portfolio could look like. Both could act as guides for you, not as manuals.

You wouldn’t want to miss them. The research will be posted on Wednesday.