In an interview with Rex Moore recently, Tom Gardner outlined why he believes that individual investors should have a widely diversified portfolio with more than a handful of stocks. I disagree, and for the reasons outlined below I think that the vast majority of individual investors should probably own no more than five to 10 stocks, with an index fund making up the balance of their portfolio. Although he approached the issue in a slightly different way, Matt Richey came to a similar conclusion in an article he wrote back in 2002.
My belief in a concentrated portfolio is grounded in two fundamental principles of value-based investing first articulated by Graham and Dodd:
- All stocks have an intrinsic value and a market value, which tend to converge over the long term. But at any given point in time, they can widely diverge. Successful investing is based on identifying stocks where the market value is significantly below the intrinsic value. Or, as Warren Buffett has often put it, buying a dollar for 50 cents.
- Estimating intrinsic value is hard to do. It takes time and effort. If it were easy to do, everyone would do it, and the gaps between intrinsic value and market value would quickly disappear -- the market would become significantly more efficient than it is today.
With these fundamental principles in mind, I believe all investors need to ask themselves the three sets of questions below.
In the interest of full disclosure, I've answered each of the questions for myself and have also tried to think about how the average investor would answer them -- using my mother as my proxy for the average investor. She's a retired French teacher who is active in her investment club in Washington, D.C., doesn't have a background in finance or economics (but she's learning fast), and probably spends eight hours per week reading and researching stocks.
Question 1: How many stocks can you understand?
By "understand" I mean really, truly understand. This requires a thorough study of the company's financials, its value proposition, industry dynamics, and the company's source of long-term strategic control. You should be able to estimate the company's intrinsic value, and your estimate should be based on fact-based research and analysis. If the intrinsic value is different than the market value, you should also be able to clearly articulate why that is the case. Although Tom Gardner and others argue that diversification reduces risk, in my opinion, diversification into stocks that you don't fully understand does exactly the opposite -- it significantly increases the risk in your portfolio.
The primary limitation for most people here is simply time and experience. Doing in-depth research on companies takes significant effort, though a facility with financial analysis helps a lot. While there are some useful shortcuts, understanding intrinsic value ultimately comes down to estimating future cash flows, based on historical records, industry profit margins, growth potential, and other factors.
I believe that a full-time, experienced investor probably has the ability to properly understand intrinsic value for 50-100 companies in no more than five to 10 industry sectors. For part-time individual investors, such as my mom, that number is probably no more than 10-20 companies in two to three sectors or industries. Investors who are just starting out may be able to really understand intrinsic value in only a few companies in an industry they know well.
Although I am always trying to expand the number of stocks whose valuation I can understand, I feel comfortable with my estimate of intrinsic value for no more than 12-15 stocks.
Question 2: Of the stocks that you understand, how many are currently trading at significantly below intrinsic value?
At any given point in time, probably no more than 25% to 50% of a group of stocks are trading at significantly below intrinsic value. In today's market, less than 10% of your well-understood stocks may be trading at significantly below intrinsic value.
For tax reasons, your portfolio may include stocks that are fully valued or even somewhat overvalued. However, any additions to your portfolio should be from only the subset of your well-understood stocks that are trading significantly below intrinsic value.
Anything that is trading at well above intrinsic value should probably be sold despite the tax implications -- in the long term, the returns from holding overvalued stocks will be lower than the market return. You most likely are better off selling those stocks, paying the taxes, and reinvesting the money, either in stocks that are trading below intrinsic value or in an index fund (see below).
If (like my mom) the average investor is capable of understanding no more than 12 stocks, and 25% of those are trading below intrinsic value, that's three stocks that she should be adding to her portfolio. Assuming three more are trading at intrinsic value, and she's not selling them because of the big tax gains she has made, her portfolio is made up of a total of six stocks.
I currently own only two individual stocks (in addition to Berkshire Hathaway (NYSE:BRK.A), which I consider to be a totally different animal) -- Costco (NASDAQ:COST) and Whole Foods (NASDAQ:WFMI). I believe that both are now trading close to their intrinsic value, but I am not selling, primarily to avoid taxes on my gains, since I have held both stocks for a long time.
There are a number of other stocks that I think I understand, but none are (yet) selling at low enough prices for me to add them to my portfolio, though a few airline stocks, such as Frontier (NASDAQ:FRNT), are getting close. I'm hoping that the market continues on its downtrend -- if and when the stocks I understand cross my margin of safety, I'll start to buy.
By answering the first two questions, you should have set a maximum number of shares for your portfolio. And unless you are a financial wizard or spend your days and nights reading financial statements, I doubt that most readers can honestly set that number much higher than 10 stocks. I know that I probably can't and that my mom definitely can't.
Question 3: How confident are you in your ability to estimate intrinsic value, and how much risk are you willing to take?
These two questions go hand in hand, and in my opinion, the answer should drive the asset allocation between an index fund and your equity portfolio. The more confident you are in your ability to estimate intrinsic value and the more risk you are willing to take, the higher the share of your assets that should be in the individual stocks that you pick.
On one end of the spectrum is Warren Buffett, who has lots of experience and great confidence in his ability to pick individual stocks. He can also afford to take risks with his equity portfolio that most of us can't -- Berkshire has more than $40 billion in cash right now. Not surprisingly, Berkshire doesn't invest in index funds.
On the other end of the spectrum would be a novice investor. He would probably want to take 80% or 90% of the money that he has earmarked for investment in the stock market and put that in an index fund. The balance he would invest in his individual stock picks.
Most of us fall somewhere in the middle. As we get more experienced, we can probably shift more of our stock assets from index funds into individual stock picks. For me, I have about 50% of my assets in an index fund, and the balance is in my stocks or in cash waiting for the stocks I follow to come down to a price that I consider reasonable for investment.
My mom still has less than 20% of her portfolio in an index fund, with the balance in cash and in her 50 stocks. I've tried to take her through the logic outlined in this piece, to no avail. And I've challenged her to prove to me that she understands how to value Citigroup (NYSE:C) and the other bank stocks she bought based on an article she read; or better yet, to tell me what the intrinsic value is of that Chinese Internet portal she owns. Despite my efforts, her irrational approach to stock buying continues unabated.
Then again, it wasn't that long ago that her arguments (in hindsight, quite rational, I have to admit) to me about why I should cut my hair also fell on deaf ears. What goes around comes around, I guess.
Fool contributor Salim Haji cut his hair shortly after he graduated from high school. He now lives in Denver, Colo., and owns shares of Costco, Whole Foods, and Berkshire Hathaway. He does not own shares in any other companies mentioned in this article. The Motley Fool is investors writing for investors.
