Portfolio construction tends to get much less attention than picking stocks. This is a shame because it’s a huge driver of risk and returns.
You can be a great stock picker, but if you don’t allocate monies effectively you’re probably not going to do very well. Poor portfolio construction can also mean exposing yourself to risks you may not even know you’re taking.
Portfolio construction is, like most things, full of contradictions. Minimise risk, but maximise returns…. diversify, but don’t over-diversify. It’s a balancing act and no one will ever achieve perfection.
It’s also a very personal thing. There’s no handbook that says you must do it this way or that. It comes down to your own attitude to risk, investment style and so on. It’s about finding what works for you.
Below I set out some of the things I think about when constructing and managing an equity portfolio. As ever, these are my own personal views and nothing should be taken as advice.
Number of holdings
Personally, I prefer a concentrated portfolio of 20-30 holdings for a few reasons:
Great business are rare. Great businesses that are also well managed are rarer still. I don’t want to ‘diworsify’ my portfolio by adding sub-par companies because I believe this increases rather than reduces risk. I agree with Phil Fisher – it’s better to own a few great businesses than a great many mediocre ones.
Good ideas are rare (at least for me!). When I have one it needs to make a difference.
I like to understand the businesses I own (especially important in a concentrated portfolio). There are only so many companies I can track and develop enough knowledge on.
Most of the best investors I know have or had concentrated portfolios, although there are exceptions (such as Peter Lynch).
When you own fewer positions, it forces you to make tough decisions. Do I really understand this business well enough? Would I be better off holding this company instead? To me this is a better approach than adding more and more names, akin to a stamp collector – there are no prizes for collecting large albums of stocks.
Many studies show that beyond about 30 holdings, the benefits of adding more positions for diversifying risk are minimal.
How much to allocate to each holding
Once you’ve decided on the number of holdings comes the question of position sizing.