How Many Stocks Should an Investment Club Hold?
The basic principles of portfolio management for individual investors also work well for investment clubs.
While the exact level of expected risk and reward in a portfolio changes depending on the attributes of each included investment, investors and investment clubs that follow a disciplined methodology can rely on a few basic principles to aid them in building portfolio with a good balance of risk and return.
Research by financial academics shows that a portfolio of 20 well-selected stocks, spread out by sector and industry and company size, will provide a very good level (and perhaps even an optimal level) of diversification.
To understand how the number of stocks affects the risk in a portfolio, consider a portfolio that includes just one stock. This portfolio is very "risky" since all of the risk and return is tied up in just one investment. Add a second stock, and you have reduced the risk by a considerable level, since a bad performance of one investment now affects the total portfolio much less. As more and more investments are added, the level of non-market risk can be reduced.
Once a portfolio grows to 20-25 stocks, however, adding more stocks does not tend to decrease risk by any appreciable level but does tend to cause portfolio returns to decrease. A portfolio of 100 stocks, for example, will not likely perform any better than nor have any lower level of risk than the S&P 500. In mathematical terms, the returns of a portfolio of stocks will see its returns “regress to the mean” returns of the overall market as more and more companies are added.
For evidence of why this is generally true, look at the mutual funds that have beaten their target indexes in any given year. The outperformers amongst managed mutual funds tend to be those funds with a very small number of holdings—often as few as 40-50 companies. Even though the expenses of these funds are often much higher per unit than for bigger funds, the outperformance of holdings is high enough to offset the higher expenses. Contrast these smaller funds with very large managed mutual funds, which seldom outperform their indexes. These large funds own hundreds (or thousands) of stocks, and so their returns tend to be very close to the returns of their target index—and then even a very small amount of expenses per share will drag down their overall performance below the returns of their index. (This is the basic premise of index fund investing.)
Another way of looking at the question of portfolio size is that limiting the number of stocks in a portfolio forces discipline. When a limit is set for the number of companies in a portfolio, and another great company is found, room must be made before that stock is purchased – by either selling an underperformer or selling an overvalued winner. (In a gardening analogy, either pull the weeds or harvest the ripe fruit before it spoils.) Doing this repeatedly keeps the portfolio concentrated on stocks with the best prospects, instead of holding onto losers for too long or buying stocks just “to see what happens.”
This focus on maintaining a concentrated portfolio also encourages investors to buy additional shares of tried and true current holdings instead of always being tempted by the bright and shiny prospects of a new stock.
It can be a good idea to gradually add more stocks above that 20-25 stock target as a portfolio’s size increases and nears or exceeds $1M, up to about a maximum of 30-35 stocks. This simply helps mitigate the magnitude of normal market or stock volatility.
To help maintain portfolio focus, my rule of thumb is that no stock should be less than 3% of the entire portfolio value. A 1% position that grows 100% overnight is a 1% total portfolio gain, which seems a sad reward for a such a large increase in price. On the other hand, a 100% overnight gain on a stock that makes up 10% of a portfolio is a 10% gain in total portfolio value, which is a very good day in the market. If you like a stock that’s only 1.5% of the club portfolio, do your best to build up that position. If you’re feeling so-so about it, then it’s best to get rid of it. Small positions are usually nothing more than distractions.
On the high side, a single stock that makes up more than 25%-30% of a portfolio’s total value is usually reaching nosebleed valuation levels. Usually these are the stocks that have performed exceptionally well, so do not automatically sell just to rebalance, but instead watch them carefully and make sure the portfolio is counterbalanced with companies that are not aligned economically with that oversized position.
This is the academic side of portfolio construction, Now on to the operational side in an investment club (which, as it turns out, dovetails nicely with the above rationale).
Each moderately-experienced club member ought to be able to manage following 2-4 companies for the portfolio. (Some clubs may choose to give officers a pass on stockwatching duties, depending on the skill and experience of the remaming memebrs and the overall size of the club and its portfolio.) For the sake of argument, a 15-member club would have 11 non-officer members, so each member would be responsible for 1 or 2 stocks (average 1.8) in a 20-stock portfolio. In a 5-member club, everyone would watch 4 stocks in a 20-stock portfolio. In a 20-member club, 16 non-officers could easily each watch 1 or 2 stocks (average 1.45).
When purchasing a new stock, the above concepts also encourage always taking a meaningful intitial position. Each club should set its own guidelines, but something around 5% of total portfolio value might be a good place to start when buying a new company. Again, the club should be trying to start a long-term relationship, not indulge in a summer fling.
As the club gets much larger and portfolio value creeps up to several hundred thousand dollars, the assumption is that the club members are much more experienced and each member can handle many more stocks on average than a new club’s members could, and that 30-35 stock portfolio still allows for minimum 3% positions by rule.
Each club gets to decide on its own procedures, but hopefully the above provides some guidance and background for developing practical policies for portfolio construction.
- DOUG GERLACH
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