When it comes to picking your own shares you have to achieve two things. You have to make profitable investments and you have to do better than the stock market as a whole. If you don't think you can do this then you should stick a chunk of your money in a cheap stock market tracker fund and get on with other things in your life.
Don't let the last sentence put you off. The good news is that by following some simple rules and a willingness to put in some work, many private investors have made a lot more money than professional fund managers and the stock market as a whole. There's no reason why you can't do it too.
As well as picking good investments, one of the key things you have to get right is owning the right number of shares in your portfolio. To sum this issue up: You don't want too few so that you can't sleep at night nor do you want too many so that your portfolio just looks like a tracker fund.
Individual shares are risky. This is because shareholders are last in the queue to get paid their share of the company's profits and could lose everything if the company goes bust. To compensate shareholders for these risks, they have a claim on the growth of a company's profits. If a company's profits grow then shareholders stand a good chance of getting richer.
So to protect yourself from bad things happening to your portfolio financial experts often tell us to spread our risks across lots of different shares and not put all our eggs in one basket. This process is known as diversification. But how many shares do you actually need to do that? And how can you make sure that you don't end up with a portfolio that looks like a stock market tracker?
First and foremost, not having all your eggs in one basket is a good idea. For example, if you have all your money invested in one company and that company goes bust then you have a big problem on your hands. By adding more shares to your portfolio, the risks of one company destroying a large part of your nest egg goes down. This is shown in the table below and is known as stock specific risk.
|Reducing stock specific risk by owning more shares|
|No of shares||Maximum portfolio loss |
from one share going to zero
This is just the effect of simple maths where the stock specific risk is one divided by the number of shares in a portfolio. Here, I am assuming that an investor starts out with their money invested in equal amounts across a different number of shares. If you have all your money invested in just one share and that share's value goes to zero so does the value of your portfolio. If you own 10 shares in equal amounts then you can only lose 10% of your portfolio if one of them gets wiped out.
If you own 20 shares you can only lose 5%. By the time you own more than 30 shares, the reduction in risk you get from adding more and more shares to your portfolio gets smaller and smaller.
What you can also see is that even owning a portfolio of 10-15 different shares in equal amounts can reduce the risks of one share blowing the value of your portfolio to smithereens. It begs the question: why you really need to own more than 20 shares in a portfolio?
In a lot of cases, the answer is yes.
Why on earth are there lots of professionally managed funds out there with over 50 and sometimes over 100 different shares?
There are lots of reasons for this and none of them are good. It mostly comes down to how the fund management industry works.
According to the famous economist John Maynard Keynes (more on him in a short while):
"it is better for reputation to fail conventionally than to succeed unconventionally."
This is best shown by the tendency of lots of fund managers to behave like herds and all own the same shares in similar proportions. By doing this they minimise their chances of doing worse than the stock market as a whole and losing their jobs.
Who - apart from the customer of course - really cares if they lose money by buying ridiculously overpriced and overhyped shares - as what happened during the tech boom in the late 1990's and early 2000's - as long as everyone else is doing it too? History tells us that under these circumstances many customers will stick with the fund they already have.
It also explains why many too many fund managers' portfolios look like the index they are trying to beat - known as closet trackers - by investing in most of the shares in that index. This is done to stop the performance of their fund straying too far from that of the index it is benchmarked against.
In other words, the manager hopes that their performance will never be too disastrous so that customers take their money elsewhere and they lose their pay packet. Yet by owning lots of shares, they can still tell people that they have a nicely diversified and lower risk portfolios in theory, but in reality the customer is left owning an expensive fund that looks very much like a cheap tracker fund run by a computer.
To put it bluntly, owning too many shares leads to an average investment return because you end up with the bad shares offsetting the performance of good shares. You don't need to pay up for that. Sadly, too many funds are run this way. But there are some good managers out there trying to the right thing.
If you want to beat the stock market you have to build a portfolio that looks different to it. In practice, you can't do this if you own too many shares. Why is this so?
If you look at the track records of very successful investors what you can see is that many of them have trounced the markets by making big, concentrated bets in a small number of investments. Warren Buffett - arguably the world's most successful investor - reckons that a successful investor only needs to make twenty great investments in a lifetime:
"I could improve your ultimate financial welfare by giving you a ticket with only twenty slots in it so that you had twenty punches - representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all. Under those rules, you'd really think carefully about what you did, and you'd be forced to load up on what you'd really thought about. So you'd do so much better." Warren Buffett
Some might rightly argue that Buffett's Berkshire Hathaway business today is very diversified by owning lots of different companies outright. However, if you look at Berkshire Hathaway's share portfolio at the end of 2014 you can see that it is making big concentrated bets in a few shares as shown in the table below.
Nearly a quarter of the value of the portfolio is invested in one share - Wells Fargo. The top four holdings make up nearly 60% of the portfolio. This is a great example of high conviction, concentrated investing. A far cry from how many professional fund managers work.
|Berkshire Hathaway Listed Investments End 2014|
|Company||Market Value ($m)||%|
|Procter & Gamble||4683||3.99%|
|Da Vita Healthcare||1402||1.19%|
|Deere & Company||1365||1.16%|
Source: Berkshire Hathaway 2014 Annual Report
Another investor who believed that holding fewer shares was a better way to invest was the famous economist John Maynard Keynes. Between 1927 and 1946, he managed an investment fund for King's College at Cambridge University. These were difficult times with the Great Depression and the Second World War but Keynes managed to produce an average annual gain of 9.1% per year whilst the UK stock market fell by an average of just under 1% per year over the same time period.
Terry Smith of FundSmith is another high profile advocate of concentrated investing. His equity fund owns just 28 different shares. Since starting in November 2010 until the end of 2014 the fund doubled in value and delivered an annualised return of 18.1% compared with 11.4% for the world stock market index (MSCI World Index).
To me, this style of investing makes a lot of sense and is one that can be copied and practiced by private investors. Here's what you need to do:
This is a strategy for investors with high rates of conviction in their ideas who are prepared to do their homework. It does not require a high level of intelligence and anyone can follow it but you do have to put some effort in.
However, it is true that by making bigger bets in fewer shares can backfire if you pick the wrong shares. If this makes you a little nervous there are a few alternatives you can explore which might make for an easier night's sleep.
One thing you could do is put some of your savings into a cheap index tracking fund and then have a certain proportion to invest in individual shares. This will lower your risks of getting it wrong but will also lower chances of beating the stock market.
The other thing to consider is owning investments that behave differently to the stock market such as bonds, property or precious metals. This is known as multi-asset investing and is a good way to spread your investment risks. I'll talk about this a lot more in a future article.
Particularly if you are new to investing, I would suggest you dedicate only a portion of your savings to picking individual stocks whilst you learn the ropes.
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.