July 9th, 2013
A good place as any for jump-starting the blog after an extended absence is with a question I recently received from a new Instant Alerts Member. It’s a vexing question for which there really is no easy or objective answer. It’s a question I continually think about and search for answers to. The question was:
“If you where starting now, what number of stocks would feel is manageable and comfortable for starting a $50K or $100k portfolio?”
Those who’ve read my book know that I omitted the topic of portfolio management … the omission was not an oversight but intentional. As a matter of fact, I had even considered the topic to be a follow-up second volume. Since the question was asked, however, I’ll begin answering it over the next several articles, comprehensive but not overly exhausting or esoteric.
Those who’ve searched for an answer on their own have discovered that there are hundreds of thousands of academic books and articles available on the subject of “stock portfolio management”. The introductory paragraph of one such academic articles entitled “How Many Stocks Make a Diversified Portfolio?” in the The Journal of Financial and Quantitative Analysis of Sept, 1987 is typical of what you might find if you were to accumulate a couple of hundred such articles [my emphasis added]:
“How many stocks make a diversified portfolio? Evans and Archer concluded that approximately ten stocks will do …. rais[ing] doubts concerning the economic justification of increasing portfolio sizes beyond 10 or so securities ….. The primary purpose of this paper is to show that no less than 30 stocks are needed for a well-diversified portfolio.”
In the next section, the authors add [my emphasis added]:
“The risk of a stock portfolio depends on the proportions of the individual stocks, their variances and their covariances. A change in any of these variables will change the risk of the portfolio. Still, it is generally true that when stocks are randomly selected and combined in equal proportions into a portfolio, the risk of the portfolio declines as the number of different stocks in it increases.”
In the end, like most research in financial and investment management is constructed in a fantasy world with unrealistic or incomplete assumptions. For example, another textbook on the subject focuses on the process involved in managing the risk of a portfolio as contrasted with determining the criteria for portfolio management success. The article summaries the process into the following steps:
“Portfolio management is a process encompassing many activities aimed at optimizing the investment of one’s funds. Five phases can be identified in the process:
- Security analysis
- Portfolio analysis
- Portfolio selection
- Portfolio revision
- Portfolio evaluation”
In short, most of the literature aims at identifying the ideal combination of various assets to construct a portfolio that offers the required trade-off between risk and return. The approaches used, however, are complex, they assume that the state of the market at the time the analysis is irrelevant, they are indifferent as to the source of those investment funds (i.e., whether reallocated or new cash infusion) and often ignore the unique characteristics of the specific individual investor and assume they will balance risk against desired risk themselves.
In the next several posts I’ll give you my view of the best way for individual investors to manage their portfolios based on my own personal experience. Rather than assuming from the start, as do the academicians, that the market is perfectly efficient and the future is known and measurable with near certainty, I start with a different set of assumptions:
- Market timing is possible and an integral part of portfolio management
- In some ways, stock selection is like buying a lottery ticket since no one can know with certainty what is the future of any individual stock
- Because of the risks and uncertainties inherent in investing, we seek to optimize rather than maximize performance by continually comparing our performance against external benchmarks.
As this discussion of portfolio management unfolds, more basic assumptions will be added. But for the time being it’s a beginning that underscores the difference in this approach to the classical academic one, a foundation for beginning to build a different approach to portfolio management for individual investors.
A member’s question launched this discussion so other topics that might be of interest or are puzzling you are welcomed. They might include such topics as (not necessarily in this order):
- How many stocks should be in your portfolio?
- What is the nature of risk and can you actually inoculate yourself from it?
- Is portfolio management different for a young investor adding new funds to their portfolio than a retiree with a stable portfolio?
- Is portfolio management different if you’re investing in mutual funds, fixed income, individual stocks or ETFs?
- How should a person’s investment horizon preference (for example, several months vs. several years) factor into their portfolio management practices?