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Deciding the Size of a Club's Portfolio
Dear Doug:
I am a member of the Classic Ladies Investment Klub in Santa Barbara, CA.
We have 9 members and 11 stocks in our current portfolio with a total
value of $17,000. Approximately how many different stocks should an
investment club of our size be capable of managing in our portfolio?
- RgrRisdall
Dear RgrRisdall:
One of the golden rules of investment club portfolio management is
diversification. A portfolio that includes stocks of multiple
personalities and demeanors is not in need of clinical treatment-it's
actually a good thing. The stocks in your club portfolio should represent
a variety of industry groups and should vary in size, and no single stock
or sector should be over-represented.
NAIC recommends that you aim for your portfolio to be made up one-quarter
large companies, one-quarter small companies, and the rest in between.
This diversification strategy will help you reduce some of the risk in
your portfolio, particularly if one of your holdings falls flat or if a
specific industry experiences problems. In addition, through the history
of the market, small and large companies have tended to perform well at
opposite times. Having a good mix of stocks can help smooth out the
returns your portfolio will generate when compared to a portfolio made up
of only a few non-diverse stocks. Of course, an all-equity portfolio will
not be immune from a correction or crash in the stock market, but that's
where your long-term approach will help you see through the short-term
gyrations of the market.
How many stocks does it take to make a diversified portfolio? For fun, you
could bring together a roomful of Wall Street professionals to discuss
this very issue, and you'd end up with a roomful of different opinions.
(Okay, so that's not everyone's idea of "fun.") But we do know a few
things that academic researchers have discovered over the years about
diversification, and there are some practical issues that come to play in
a club setting, so here are some general guidelines.
Most professional investors say that a portfolio of 15 to 20 well-chosen
stocks will give you most of the benefits of diversification. While you
could decide to own more stocks than that, there's a problem with owning
too many stocks. It should be the goal of your club to outperform the
overall market (probably as represented by the Standard & Poor's 500
Index) over time. If this isn't your objective, then you could just invest
in an S&P 500 index fund and give up the stockpicking altogether! But as
you buy more and more stocks, your portfolio's returns will tend to draw
closer to the returns of the S&P 500. The more your portfolio looks like
the S&P 500, the smaller your chance of outperforming the overall market.
Having "too many stocks" can be a problem.
In your club, you have other concerns, as well. First, you can only own as
many stocks as your individual members can manage to follow. Each member
should be the analyst or stock watcher for one (or more, occasionally)
stock in your club's portfolio, providing monthly progress reports and
other regular updates to your members. Nine members should be able to
track 11 stocks, but that may put a significant workload on some members,
especially if some members are new or have other duties (such as serving
as club officers).
Next, it's important to remember that diversification is a goal towards
which your club should work, not something that should happen overnight.
There should be no rush for a new club to buy a dozen stocks just so they
can be diversified. It's more important to pay attention to the
transaction costs you'll pay and how they impact each purchase. Even with
today's discount online brokerages, you still must pay a commission for
each purchase. If your brokerage charges you $12 per trade, and you invest
$500, the commission will take a 2.4 percent bite out of your purchase.
That's a full point above the average expense ratio of a domestic stock
mutual fund! When you consider that the stock market on average grows 12
percent a year, that 2.4 percent sets you back quite a bit (in fact, the
$488 your investment is now worth after commissions must grow 2.46 percent
just to get back to even). If you invest $1,000 instead, that $12 only
amounts to 1.2 percent, much more in line with my standard recommendation
to keep your trading costs as close to 1 percent as possible.
The other concern is the size of the club's portfolio. As your portfolio
gets much larger, surpassing the $100,000 mark, you might want to add more
stocks to your holdings. It's not unreasonable for clubs of this size to
hold 20 to 25 stocks in their portfolios. But the members of these clubs
are likely to be much more experienced, having been in their club for a
number of years, and can handle the management tasks without problems.
In your club, I think you should think carefully before adding any more
stocks to your holdings. But that doesn't mean that you should not be
considering any new companies-to the contrary, you should be focusing on
new stocks that can improve the quality, diversification and return of
your portfolio by replacing weaker holdings with your best new finds.
NAIC's Challenge Tree is great for this job, so follow this prescription
and put your current holdings to the challenge. Focus on upgrading rather
than expanding your portfolio.
-- Doug
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