Ask Colin

I have too many stocks in my portfolio because I am afraid to put toomuch in one stock. Is this OK?

The detailed question was:

I have a portfolio of about $5 million. I struggle to keep the number of stocks I hold below about 40-50. I seem to have a comfort zone of around $80,000-$100,000 per stock. I have one or two that I hold around $200,000, but in the main that's the size of the parcel I can’t seem to pluck up courage to buy more of. So I end up with about 45-50 stocks which I feel is too many. Yet there are few I want to let go.


First, let me make two general observations:


Observation One: You have asked an important question. It is one that I am asked from time to time. It is also one that I have personally wrestled with, especially when, a year or so ago, I switched additional funds from selling other assets into my share portfolio. What you describe is a very real problem. To quote an old joke, size does matter. If you want to climb mountains, you do not start with Everest, you work your way up to it by trying smaller peaks first. Let’s say that you and I were betting on something between us. We might be having real fun betting $100 on who would win the next cricket test. But suppose I offered to bet you $1 million on the next test. Size does matter.


Observation Two: There are few absolutely right or wrong answers in investing. At the extremes there are possibly some right and wrong answers. Say you put the whole $5 million on one stock. Or that you only put $5,000 of your $5 million on 1,000 stocks. Both of those could be said to be wrong. But at the margins in the middle somewhere, it is not so easy to make absolute judgements. If we were to discuss whether you should stretch from $100,000 to $150,000 per stock I don’t think there is an absolute right or wrong judgement that can be made about that.


When I wrote my book The Aggressive Investor (now called Building Wealth in the Stock Market), one of the problems to solve was the name of the book. I decided that Aggressive was the right word. Yes, it has a double meaning. That added to its appeal, because it made people stop and think. The important meaning of aggressive is the antonym of passive. I am not a passive investor. I have an aggressive or active management style. Some people say that I am a conservative investor. I argue that an investment plan is a balance of factors. Yes, there are some areas that I am conservative about – no leverage – but this just balances the aggressive areas. One of the aggressive areas is the concentration of my portfolio into 15-20 stocks when fully invested.


The reason for this very aggressive style element is that I am trying to match or beat the market index. That is not as easy as it sounds. If I have a broadly diversified portfolio, it will be difficult for me to even match the market index. To beat the market index, I have to be holding fewer stocks than the index. I am not big enough that I must hold most of them, but overweight some, which is what a big funds manager must do to try to beat the index. My strategy is to focus narrowly on very strong stocks. I hold them while they are trending up, but am ruthless in cutting them if they fall out of their trend. I have another advantage over a big funds manager. I can move very quickly from cash to fully invested and back into cash again. It is rare to make such a big move, but I have recently reduced my exposure to the market significantly on this strategy.


The proportion of the portfolio that is invested in any one stock is not the only place in the investment plan where this issue of size crops up. When my portfolio was much smaller, I used to risk up to 2% of it on any one stock. As the portfolio became larger, I reduced this level of maximum risk to 1%. However, although I have left the plan at 1% maximum risk, I very rarely go near that level – 0.5% is a more normal risk for me and it is often even less than that. If you have a $5 million portfolio, then 1% risk is $50,000. If your position size is $80,000 - $100,000, that is a big hit and I doubt if you will be risking that much on one stock.


So, what it comes down to I think is this:


On the one hand, as your portfolio grows, I would expect you to risk a lower percentage of the portfolio and to also invest a lower percentage on any one stock. I do not see a problem with 45-50 stocks, so long as you have the time to devote to managing them and do not become lazy in your decision-making because one seems not to matter that much in the total scheme of things. This is a common problem in a bull market.


On the other hand, if you extrapolate this into the future, when you have a $10 million portfolio, you would be holding 90-100 stocks. That could be a problem. Do you have the time to manage them? Would you be content then with close to the index return, because that is what you would be simulating, give or take a bit? I suspect not.


In summary then, I don’t think what you are doing is wrong in any absolute sense. However, the fact that you sent me this question is suggesting that you are not entirely comfortable with it. I don’t think it would be wise to change what you are doing in a sudden jump. In other words, to move in one step from $100,000 in 50 stocks to $300,000 in 17 stocks would not be smart. But I think you should consciously try to move. Right now you are at about 2% of capital invested in each stock. Try to move that up in slow steps. Consciously set yourself 2.25% of capital ($112,500) for the next year. Then move it to 2.5% of capital ($125,000) the next year. As the portfolio grows these percentages should be the guide, rather than the dollar amounts. That way, over time, you will focus your portfolio more than it is now. You will also avoid it becoming more and more diversified, which tends to bias the results to mediocrity. How big these steps are is up to you. Also how far you take the process is also up to you. Maybe you aim to get from 40-50 stocks down to 35-40 stocks and hold it there. This might be as far as you ever want to reduce it. Because I am more aggressive does not make me right or wrong – just that my plan is different. Remember too that as your portfolio grows, working with a percentage of capital means the position size increases each year. So, once you are at 35-40 stocks (say), you will still be increasing the size of your average position each year.


One aside is that all stocks are not the same. I have a maximum of 6% of capital going into any one stock and a minimum of 2% of capital. Part of my plan is to exploit some small and thinly traded stocks. For some of these 2% or 4% may be all I ever put into them because of the liquidity risk. Nothing is cast in stone in this game of investing. Each case must be considered on its merits.