Portfolios perform best with between five and 20 stocks. Fewer than five leaves you unable to achieve portfolio balance and diversification; more than 20 and it is hard to stay informed.
When we offer investment guidelines, rules-of-thumb and so forth, we are talking about top-quality investments—such as those on our Investment Planning Guide’s list of Key stocks.
Virtually all our Keys are long-established companies with a strong grip on their markets. When their industry flourishes, so do they. When their industry slumps, they may lose money, but chances are they’ll also lose some competitors.
Our Keys are the kinds of stocks on which we base our five-to-20 stocks rule. But you may want to depart from this sort of investing from time to time. You may want to profit from—bet on, you might say—a powerful market trend, or an unusual set of circumstances. For instance, you may want to invest in a rebound in gold prices by buying low-priced gold stocks. Or you may want to profit from a continued rise in technology stocks.
From the top down
Focusing on trends or specific developments, rather than on individual company fundamentals and investment quality involves extra risk. It’s a variety of what professional investors refer to as the ‘top-down’ approach: you are buying because of a market prediction, always a risky business. You compound your risk when you apply this dicey approach to below-average quality investments.
So rather than choose one stock, you may be better off spreading out your risk with a package of three to five stocks that will all gain or lose from the outcome of the trend or unusual set of circumstances. Some of your picks are sure to stumble. But if your basic belief—that gold will rebound, cloud computing will keep soaring or whatever—holds true, you may also wind up with some extraordinary gains.
You should treat the package as one stock when you decide how many stocks to hold in your portfolio. After all, a single prediction is what made you decide to buy the stocks in the package.
Applying the package approach
Ordinarily you only apply the package approach to riskier, more volatile, less-well established companies. Many of these will be of average quality or lower. But at times of high investment uncertainty, when a single factor can make a big difference, you may even want to take a package approach with higher quality companies.
For instance, if you believe that cloud computing is in for a continued surge (as it may be), you might invest in a package of technology stocks like Alphabet, Amazon and Microsoft. Or you might suspect, as we do, that hard-pressed, high-quality Canadian oil and gas stocks will on the whole escape bankruptcy and eventually recover. If so, you might buy a package of Canadian Natural Resources, Cenovus Energy and Suncor.
Junior oil and gas producers lend themselves to the package approach. They labour under a number of special risks—fires, floods, cave-ins, transportation to and from remote areas, political change and so on—on top of the usual variations in the price of oil, and in the price and saleability of natural gas.
Spread your funds in higher-risk sectors
If you bought Cenovus above $10 earlier this year, you may feel tempted to buy more at the current $6. Before doing so, first consider if you should invest more money in the resource sector; if so, you may be better off to build up a package of oils, rather than buy more of the one you now own, simply to lower your average cost.
In short, it’s okay to own just one major bank or only one phone company in your portfolio. But in sectors of higher risk or lower quality, it pays at times to spread your funds around. Whether you buy a single stock or a package, however, all the usual caveats apply. A package of stocks should have a meaningful but not undue impact on your portfolio; that package should be worth anywhere from five to 20 per cent of your portfolio’s total value. When following this approach, it pays to apply the ‘sell-half rule’: sell half of any (package) stock you own that doubles, so you get back your initial stake.
This is an edited version of an article that was originally published for subscribers in the June 5, 2020, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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