Portfolio Management and Asset Allocation

I’ve generally never held more than 15 stocks in my portfolio at any one time.

I first started investing with $3000 and with each trade costing $12.95, it didn’t make much sense to break it up into 10 positions each making up $300.  Although my portfolio has grown as I kept adding cash along with the capital appreciation, I have never felt the need to add more stocks or re-balance my positions. It was either sell the entire position or keep it.

Recently I’ve liquidated two of my positions which I will detail when it comes time for a July portfolio update but one reason for the sale was that I was finding it hard to fully understand and keep up with the business. I must admit that I didn’t perform as much due diligence on that one and I preferred to sell something I wasn’t so sure about.

This leads to the discussion on concentrating a portfolio or diversifying, which Peter Lynch called deworsifying.

I don’t over concentrate by investing in only 2-3 stocks where the size of one position may be greater than 50% but I do prefer to hold anywhere between 10 to 20 stocks.

Diversify or Concentrate?

The common adage is “not to place all your eggs in one basket” because when something goes wrong and you drop it, a majority of the eggs will break, but then again, a few may not.

But what happens if you place every egg into its own basket? How do you carry 50 baskets? You are just as likely to drop 40 of them.

However, although value investors most often have concentrated portfolios, other types of investors such as pure dividend income investors, safety seekers, mutual fund investors and bond investors are best to diversify as people following this type of strategy tend to dislike volatility.

Diversify or concentrate.. it’s a common argument between many people so I’ll just end this section with a good reason for diversification.

We want to have enough good ideas at work that if we’re wrong or unlucky on one or two, we haven’t lost a significant amount of capital. It’s not unusual for us to make a good decision that has a bad outcome – this is a probabilistic business. If you’re really concentrated and have two bad outcomes out of ten perfectly good decisions, 10% of  our portfolio can blow up. I’ve heard the argument that if you have your top ten best investments, why would you want to dilute it with your 11th best investment? But if I had to order my top ten ideas by how much I thought they’d go up, I guarantee you that wouldn’t end up being the top ten in actual performance. So we’re just more comfortable being somewhat more diversified. – Zeke Ashton

Constructing a Portfolio

Whenever I find an opportunity I compare it with what I currently hold. This way, I can decide whether I should sell something to make room for the new idea or to keep everything as it is but include the stock idea as a small starting position and gradually build my way up.

This method also helps me to decide how much capital to allocate to the position relative to the overall portfolio. A mistake I made at first was simply buying the same amount in a stock regardless of the potential.

The following is a quote by David Einhorn which is a much better articulated explanation of how I construct my portfolio.

We believe in constructing the portfolio so that we put our biggest amount of money in our highest-conviction idea, and then we view the other ideas relative to that. We find things that we think are exceptional only occasionally. So if we find something that is really set up, where we think it’s mispriced, where we have a good understanding of why it’s mispriced, where we think the mispricing is very large and the overall risk is very small, we take an outsized position to make sure we give ourselves the chance to be well compensated for getting it right. – David Einhorn

What To Do?

I hate to leave this post open ended but the truth is that asset allocation and portfolio management is up to the individual and knowing thyself. Some people are perfectly content with holding 3 stocks while another person may need 30 to feel safe.

Just putting something out there for you to consider if you haven’t done so.