However good a stock picker you are, if you don’t allocate effectively you’re probably not going to do very well and you may also expose yourself to hidden risks.
Portfolio construction is a very personal thing full of conflicts; minimise risk, maximise returns, diversify, but not overly so.
It’s a balancing act, and there is no ‘right’ way, it depends upon your attitude to risk and investment style - finding what works for you; here are some of the things I consider when constructing and managing my portfolio.
Phil Fisher, US investor and author of ‘Common Stocks and Uncommon Profits’ said ‘it’s better to own a few great businesses than a great many mediocre ones’ and I agree.
Great businesses are rare, well managed great businesses even rarer; I don’t want to add mediocre companies for the sake of it and increase my risk; I prefer a portfolio of between 20-30 holdings for a few reasons:
I like to fully understand the companies I own, and there are only so many I can develop a deep understanding of; most of the best investors I know have concentrated portfolios.
Taking fewer positions forces you to take tough decisions; do I understand this business well enough? Would I be better off holding that company instead? This approach really allows me to focus in on the companies I own; studies show that beyond about 30 holdings, the benefits for diversifying risk by adding positions is minimal.
When it comes to deciding on the sizing of my positions I focus first on risk rather than potential returns when determining my biggest positions.
The bulk of my portfolio consists of lower risk businesses that provide essential goods or services, with repeat or recurring revenue that are relatively simple to understand.
I take smaller positions in companies I deem more risky, either because they have obvious sensitivity to changes in the economy or because there is a part of their business that I understand less well.
Holdings change relative to one another over time, but unlike some investors I do not regularly re-balance to keep weightings fixed; constant tinkering by pruning winners and topping up losers leads to higher trading costs with no guarantee of better returns.
I let my winners run, and if a holding performs well it earns itself a bigger position in the portfolio.
I prefer to spend my time better understanding businesses than trying to time buying and selling decisions which, like most investors, I’m not very good at. Most investors will have made a decision to sell a holding because we thought it had run out of puff, only to watch it then double in price; if a stock is performing well or badly there is usually good reason, so I try to keep trading activity to a minimum.
I avoid having too much exposure to any one sector; I generally try to own the best business in a sector and shun the rest. However, focusing on sector alone isn’t enough and can often give a false sense of diversification; you also need to consider any overlap in terms of customers, geographies, industries served and ensure that each holding offers something different.
For example if you own a pub group, a restaurant chain and a traditional retailer, you’re not only concentrating your bets on UK consumer spending, but on High Street footfall - a very narrow remit, and unlikely to pay off.
By the same token, if you owned Barclays, Persimmon and Purple Bricks you’d be invested in three different sectors (banks, house building and estate agency) but in the same theme that will all suffer from a decline in house prices.
The same can be true in industrials where companies offering a wide range of seemingly unconnected products are actually all plays on oil and gas prices.
The corona virus crisis will inevitably cause investors to think even harder about how well diversified they are; consumer-facing businesses that rely on people stepping outside their homes have been hit particularly hard.
COVID-19 was a bolt out of the blue, but prudent portfolio construction as a matter of course blends consumer businesses with those supplying goods or services to other companies.
The crisis has prompted me to think harder about how many of the companies I own provide truly essential goods or services, as opposed to serving more discretionary pursuits.
I started by saying that portfolio construction is a very personal thing, and it has taken me a number of years to come up with a method that I am comfortable with and that is replicable; it doesn’t mean having exposure to every sector or theme, you have to choose your bets carefully.
I have specifically avoided talking about individual companies because these basic principles can be applied across any sector or theme; the more companies I investigate, the more I can identify common threads, but also the points of difference that make some companies exceptional.
I have become adept at identifying companies that fit my method and objectives, and adding those that do not, just because of the assumed diversification benefits, is not something that I do.
Investors often come up with complicated dependencies to explain why they hold certain stocks with the overriding principle of diversification; ‘if interest rates do A, B will happen which will benefit C’.
I prefer to focus on key aspects such as the quality of a company’s business model; in my experience the pursuit of diversification for diversification’s sake leads to compromising other aspects of the investment case and can introduce unintended risks into a portfolio.
Constructing a successful equity portfolio doesn’t need to be complicated; own a small collection of great businesses and make sure each offers something different.
It’s fine to have three or four broad themes to a portfolio as long as they are played via different customer groups, industries, geographies and so on, rather than concentrating too narrowly.
I’ll not pretend that I’m not sitting on some chunky paper losses just now, but for me investing is absolutely for the long term; the factors that motivated me to buy particular companies remain strong so I’ll wait for things to get better as they inevitably will.
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