Portfolio allocation, page-36

@hcosah

Here are my two cents, in reply to your main questions above:

I gather from the repiles in this thread that most undertake fundamental analysis as an individual on their private account. If so, in terms of your investing philosophy, what is the maximum number of companies you are willing to hold in your portfolio? What forms the basis of your limit.

I personally don’t invest in anything that I am not prepared to allocate at least 1% of my investable capital to, as I don’t see a smaller allocation as being worth the time and effort required to do a proper due diligence; this minimum 1% purchase amount does not necessarily have to be made all at once, though: I too like averaging in, and/or buying a smaller amount first plus setting a results-based hurdle for investing the balance.

Either way, I do want to keep some cash available for the possible full purchase, which sets a natural upper limit of 100 simultaneous holdings for my portfolio. At the moment, I am holding in total 38 different securities (apart from cash and cash equivalents), with the Top 5 representing ~24% of my investable capital and the Top 10 accounting for ~40% of it.

As stated in my previous post under this thread, my general guiding principle is that one should “bet their beliefs”, i.e. to a higher degree of conviction should correspond a heavier portfolio weight; nonetheless, no matter how convinced I am, I try to never allocate more than 10% of my investable capital (on a cost basis) to a single company.

My observation is that rarely would a full time professional analyst cover more than 20 companies (usually from one or two sectors) and of course they are not trying to construct a portfolio. As individual investors do we limit the potential performance of the portfolio if we exeed a certain number of components?

It depends on how you add securities to your portfolio: if the expected yield of each of your additions is not higher than the aggregate expected yield of your existing holdings, then it is unlikely that your overall return (on invested capital) will improve as a result of increasing the number of portfolio components. So, that is one thing to keep in mind.

On the other hand, I think there are at least two more considerations to make, namely 1) what yield improvement each addition contributes to your total investable capital, in absolute terms, and 2) what diversification benefit is associated with each addition, as opposed to simply increasing the weight of your existing holdings.

To give you a bit of an extreme example: let’s say that my total investable capital is 80% in cash, 10% in company A and 10% in company B (on a cost basis); if my investments in A e B have each a 20% pa expected yield, and the best I can find in the market is a company C that operates in a sector uncorrelated with A and B and has an expected yield of 15% pa, then I will be happy to allocate 5% of my investable capital to C, because:

a) It will increase the expected yield of my total investable capital, from 20%*(20.00% pa)+80%*(0.50% pa) = 4.40% pa, to 20%*(20.00% pa)+5%*(15.00% pa)+75%*(0.50% pa) = 5.13% pa.

b) It will not add correlated risk to my existing investments in A and B, where I am already maxed out.

c) It represents, in absolute terms, an adequate return for my personal objectives; in other words, I would be satisfied if my overall expected return on invested capital drifted towards 15% pa as my portfolio construction progresses.

So, to conclude: as long as it is carried out in a principled way, I think the process of adding new components to an investment portfolio can protracted long enough to allow for a significant amount of diversification, without jeopardising the overall expected yield.

Also, is there anything useful you've learnt in the last 6 months that you think builds your armoury?

March 2020’s market crash, for me, was the confirmation that there is valuable optionality in keeping a large cash allocation (or some other form of hedge) when the prevailing intrinsic yield of marketable securities is too low; I entered the downturn with ~45% of my investable capital in cash, and that gave me the flexibility to put substantial capital at work at significantly higher expected yields than I would have otherwise been able to achieve (and that's even factoring in the negative impact of having zero yield on that capital for as long as it was kept in cash). So, if it has to boil down to one line, my key takeaway from the last six months has been that it is rarely optimal to be fully invested (or 100% long, if you prefer).

Cheers