Rule Breaker Investor Trait No. 5: 5% Maximum for an Initial Position

Not to praise our Motley Fool co-founder too obsequiously, but David Gardner has a remarkably good track record in the market. Does he only pick winners? Heck, no. But does his portfolio of stocks outperform the market fairly consistently, and over the long term? Oh yes, and by an appealing margin. (Feeling skeptical? Look deeper into our website and see for yourself -- the man keeps score of his performance with ritual consistency.)

Naturally, you might want to replicate such profitable results, but to do that, the answer isn't simply to copy his stock buys -- it's to emulate his investing style. So on this week's Rule Breaker Investing podcast, Gardner shares the six core traits of his investing philosophy.

In this segment, he talks diversification and portfolio balance, but with a number of caveats. The guideline that says you shouldn't open a position as more than 5% of your portfolio is one thing -- but how does it square with the ideas of adding to your winners or letting winners keep winning? What do you do when following the Rule Breakers path gives you a portfolio that's heavily overweighted to just a few stocks? Gardner explains.

A full transcript follows the video.

This video was recorded on Sept. 19, 2018.

David Gardner: Trait No. 5: Remember, we've got the mnemonic going on. There's going to be a five somewhere in this one. Listen for it. "5% max initial position."

That's right. When I start investing, and when I build a portfolio, whether I'm building one for myself or somebody else, I never start a position with more than 5% of the overall money we have to invest. What that means is when you build a well-constructed portfolio as a Rule Breaker investor, you're going to be diversified across at least 20 companies, because simple math suggests that if you max it out with that initial 5% position, then you would have 20 of those, and that would be your portfolio.

Now, you don't have to be as hardcore as I am on this. A lot of us start investing with smaller amounts of money and we have to put in one-third of that just to buy one stock when we have our first three stocks. So realize that of course I'm talking about a slightly more mature portfolio.

But these days since it's possible to buy fractional shares and it's easier than ever before to invest without commissions, I think you owe it to yourself to think diversified from the get-go. And especially as you grow that portfolio over time, even if you have a really strong conviction; even if the next pick coming out of Motley Fool Stock Advisor sounds really great to you, I do not think that you should put any more than about 5% or less of your full portfolio into that stock or any other.

To go back to Igor's friend [I'm glad we don't even know his name, and I don't mean to be picking on him, and I'm pretty sure I'll never meet him], but he wasn't able to keep investing because he overloaded into stocks. And I frequently have come across Fools. I've signed some books at book signings over the years. Given talks lots of different places and people come and say, "You know, I put too much in this one or that one." I see it on our discussion boards at The Motley Fool at Fool.com. People will talk about how they made that mistake.

The good news is they're talking about it which means [a] they've acknowledged it and realized it and [b] often they're looking back to an earlier stage of their investment lives when they realized they just put too much in something that sounded too good and they learned a hard lesson that way. So the best way to escape that very common trap, that truly can sink people's fortunes, is not to overload in any one stock.

Now, I will say this. A corollary to our Rule No. 5, 5% max initial position, is that if the stock starts doing well, we've said Rule No. 2, you can add to it. Add up instead of double down. And if you're doing the math with me, well if this thing started at 5% and then it started gaining in value and we added some more, it could end up being a large position; far larger than 5% in the portfolio.

And there's some nuances to this and it's very contextual [one person's portfolio to the next]. Where they are in life and how else they're invested, so I can't give any kind of all-encompassing answer to this other than to say that as a Rule Breaker I am comfortable with an unbalanced portfolio.

I've lived long stretches of my own adult life with unbalanced portfolios overloaded in a few stocks, but the only way that ever happened was because they won their way to that share of my portfolio. They earned their market share within your portfolio or mine. And since the winners tend to keep on winning, it's not always true, which is why if you have an uncomfortably large position, I would be the first to suggest you sell it off, a little bit intermittently, and get it down to where you're comfortable.

But more often than not, you should be letting your winners win, and if you have more than one of them, they won't overtake your portfolio because they'll start hitting shoulders against each other because they're all big dogs for you. And that's kind of how Rule Breaker portfolios that I've managed, for example for my kids that I built up over the years; that's kind of what they look like.

And it's a really great feeling. It's not just all about one stock. It's some big-shouldered, for-profit public companies doing great work in this world that are just growing and dominating. And when you have new money to add, I probably don't add to those anymore. I find new stocks. That's why we keep coming up with a stream of new ideas in Rule Breakers, Stock Advisor, or Best Buys Now for members so they can hear about new stocks. So to close this one out then, Trait No. 5, 5% max initial position.

And the quote I want to append here, to No. 5, is this one. "Stocks always go down faster than they go up, but they always go up more than they go down." So do remember that first part, in particular; that stocks always go down faster than they go up, and people who have overloaded in a position that starts going down fast [which never feels good, but that's always how it does feel, especially in bear markets], that can scare people out of that stock or out of investing altogether.

So part of being able to accept, psychologically, watching something go down fast, even though over time it will go up more than it goes down, is being diversified.