Challenging conventional wisdom

Friday, 11th August 2017 16:07 - by Eric Chalker

How many different shares should one hold?  By a nice coincidence, two seemingly conflicting articles recently appeared within the space of three days.  First, Investors Chronicle told readers on August 4 2017 that “concentrated positions can unlock fast, outsized gains,” while another Financial Times’ publication, FTfm, published three days later for fund managers, highlighted “the risks of a concentrated position.”  What to make of this apparent contradiction?

Investors Chronicle

To be fair to Todd Wenning, author of “Investing Cracked” in Investors Chronicle, he acknowledges the benefit of diversification for wealth protection, but he is convinced that this is not the way “to build wealth” quickly.  To make his case, he states (although quoting only one source), “Various studies have shown that the fewer shares you own, the better the chance you have of materially beating the market.”  He makes reference to one particular study in which an increasing number of randomly selected S&P 500 stocks were tested over a 15 year period: this concluded, hardly surprisingly, that the greater the number, the less the chance of beating the whole 500. 

Any sensible private investor, though, is hardly likely to pick stocks randomly.  The whole point about picking stocks is to pick those that will do better than the market as a whole.  In the absence of stock picking, a tracker fund might be a good strategy, as Mr Wenning suggests, but there’s a flaw in that suggestion, which becomes very apparent when the market turns down and the tracker plunges with it.  The same might also be true of a generalised investment trust, such as one would invest in for safety and not with the expectation of beating the market.

The Investors Chronicle article looks at various strategies for building the concentrated portfolio which its author advocates.  Perhaps unfortunately, he gives as examplars two fund managers who have recently suffered damage to their star status because they held and strongly advocated some specific stocks which have recently fallen dramatically – including AstraZeneca, Pearson and Provident Financial.  So, choosing the right companies in which to invest is critical if the aim is to beat the market – or, indeed, serve some other specific purpose such as to provide a good income. 

However, Todd Wenning’s argument is that, “owning fewer shares can help you make the most out of your best ideas” and that is the point of his article.  The problem is, as he more or less acknowledges, they have to be the right shares, so having a concentrated portfolio means having the ability – and, let’s face it, the time – to do the necessary research and thinking to enable the right choices to be made.  Even then, as Neil Woodford and Nick Train have found, even the “best ideas” can turn out not to be so, which leaves us, so to speak, still at the starting gate.

FTfm ‘Viewpoint’ 7^th August 2017

Most private investors who read the Financial Times do so only on Saturdays, but it comes with a supplement on Mondays which I find very informative, carrying news and opinion which professionals need but some of which can also be of great value to private investors.  

An article by Tom Boczar was of interest simply because it focused on the risks of trying to “build wealth quickly” through a concentrated portfolio.  The title was, “Stock protection funds cut the risks of a concentrated position.”

Mr Boczar argues that, “Holding a concentrated position for a long period without protection is riskier than most investors realise.”  He quotes JPMorgan and Goldman Sachs research which shows, in relation to US stocks, 320 stocks were removed from the S&P 500 due to ‘business distress’ in the past 35 years and 25 per cent of the Russell 1000 lost more than three quarters of their value and failed to recover it.  He then reveals it is now possible – but only in the USA it would appear – to buy into ‘stock protection funds’, which pool risk for limited periods and so insulate investors against large losses in individual stocks.

This warns us, in case we didn’t know, that ultimately no stock is totally safe against a severe capital loss, but his article doesn’t help private investors in the UK guard against this.

An alternative approach

It is obviously the case that if one holds very few stocks and these include some which perform spectacularly and none of them fail then the portfolio will do very well indeed.   But it should also be blindingly obvious that if too many of these stocks do badly and none do better than average, then the chance of “building wealth quickly” will have disappeared and may have been lost for ever.  With hindsight, the concentrated positions that would have unlocked fast, outsized gains will be easily identified, as will those which should have been avoided, but when foresight is required, even Warren Buffett has shown he can’t get it right all of the time.

This is one of the reasons that I like to have large portfolios with, in the main, unconcentrated positions.  Mine have for years comprised over 100 listed stocks, currently 112 with 62 held principally for income.  With such a spread, the chance of an “outsized gain” is limited, but so is my chance of losing a painfully large sum of money.  Clearly, the number of stocks one holds must be related to the total money one is able to invest, but the idea that, ‘the greater the number, the poorer the performance,’ is fallacious.

My strategies are to build and develop portfolios designed to deliver, on the one hand, an above-inflation increasing income and, on the other, to deliver good net capital gains.  Combined, these strategies have given me a total return which subtantially exceeds the FTSE All-Share Index return.  I have already written about dividend-oriented portfolios (“A rewarding strategy” 31^st Aug 2016) and I will in due course write about achieving multiple capital gains by selling and reinvesting.

Eric Chalker, UK Shareholders’ Association Policy Co-ordinator & Director, 2012-2016