Recently I attended an event where one of the speakers was Nerina Visser, head of Beta Solutions at Nedbank Capital. She made a comment that got me thinking about this week’s topic. She was talking about a stock’s inf luence in an index. For example, BHP Billiton* has 10 times more weighting in the All Share Index than all the gold miners put together. So a 10% move from all the gold miners would only match a 1% move from BHP Billiton. In other words, the gold miners have little or no influence within the index while BHP Billiton has huge influence in the index.
We should view our individual portfolios much like an index in that each portfolio has a f inite number of shares with specific weightings per share. Sure, the number of shares and size within the portfolio can and will f luctuate over time, but we need to give thought to the makeup of our portfolios and the influence of individual stocks in the portfolios.
I’ve written before about the core/satellite construct of my portfolio. I maintain a core portfolio of exchange-traded funds (ETFs) that sits at around 44% of my portfolio, a high-risk number. The ETF component should be between 50% and 100%, with 100% ETFs being low-risk for a stock portfolio, as the biggest risk to an individual’s portfolio is an individual stock blowing up. I add to these ETFs every month and if the figure drops below 40%, I stop buying individual stocks and only buy ETFs until their percentage is back above 44%.
In terms of individual stocks, how much of a stock does one buy when entering a position? For me, the rule is that the new stock must make up a minimum of 2.5% to a maximum of 5% of the entire portfolio. The decision between the low and high number would be based on my assessed risk of the investment. Sure, I am figuring that the risk is manageable, but for example, a lower liquid small cap would likely only get around 2.5% while a large blue chip would easily get 5%. This means that the blue chip has double the influence in my portfolio than a small-cap stock and on a risk/reward basis, makes sense.
But what happens when a stock rallies, skewing that percentage? For example, When I entered into Capitec*, it was 2.5% of the portfolio but it has since gone up almost tenfold and, while the rest of the portfolio has done well, Capitec would now have around 11% of the portfolio. That I can live with, but if it had started hitting 20%, I would’ve simply sold a few to rebalance to a more weighted risk profile. Now, I hate selling, but having a fifth of my investment world in one stock is a huge risk.
I also look to manage the risk by only having two (or at a push three, but I haven’t had that situation in many years) stocks from any sector in my portfolio. That is in part about managing sector-specific risk but it is also because if I can’t decide which are the two best stocks in a sector then, frankly, I haven’t done my homework well enough.
All in all, it means that I have a balanced portfolio without too much risk in one stock or sector, but it also ensures that a winning stock will positively benefit my portfolio.
Simon Brown heads justonelap.com, a free resource of f inancial information and investment education.
* The writer owns shares in BHP Billiton and Capitec.