The Tough Question of Good Portfolio Construction and Management

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2:09All right, folks. Welcome to Investing for Beginners podcast. Today, we're going to answer a great listener question we got recently. Newsletter at einvestingforbeginners.com, which is a great place you can send us any questions you might have. So this is from Perth, Australia, and they're responding to a request that we made in one of the episodes regarding suggestion for future episodes. And they said, it would really help me and hopefully lots of other investors if you could have an episode that deep dives into portfolio construction and management. In particular, could you please share your thoughts on the following?

2:44I'm not going to read all of them because there's a lot here. but how we structure a portfolio, including allocation, sizing, how many companies, and portfolio management. The person's name is Ashish, and again, they're from Perth, Australia. So this is a great question. With that, maybe let's start. We're talking about portfolio construction and management. When I say those words, what does that mean to you? It's just how big are each of the stocks in my portfolio? How many stocks do I have? Those are the two main questions. Yep. Yep, exactly. When we're trying to think about structuring a portfolio, how do you think about allocation into each new company?

3:23Yeah, I mean, I'd be curious. I'm just a guy, right? I'm just one guy with a portfolio. So the way I do it doesn't necessarily need to be the way other people do it. But if we think about the spectrum and the extremes of how people do portfolios. I think for each of these topics that Ashish brought up, which are all excellent, thank you for writing these in, I fall on different sides of the spectrum for each of these topics. So I think it'd be useful for everybody if I'm happy to talk about mine, but then also talk about maybe some of the extremes on either side. And hopefully that breakdown will be educational.

4:03Allocation into each company. I'm a math guy. I'm a probabilities guy. I'm the guy who's watching Survivor. And when they have to decide between taking a risk or not, I'm the one telling my wife, see, they should have taken the risk because if you add 0.33 to 0.5, then the probability is over 75%. You should take that bet every single time. I'm that guy. So when I look at portfolio and company allocation, I have all of those things in mind. So for me, I've settled on some guidelines, guideposts to what I'm trying for different sizes. And I break it down into, I have a full position size, I have a starter position size, and then I have sort of like a feeler, not even a starter.

4:51It's like a prospect. I'm just dipping my toes. So if I'm looking at a full size, I want something around six and a quarter. If it's a starter size, I want something one and a half percent for each of these. And then the prospect can be the prospect. So I am definitely thinking about portfolio construction a lot. I'm definitely thinking about allocation a lot. And I do believe it's very important. And not only do I believe, but it's been proven through track records of many, many investors that it is very, very important. You don't want to be the best stock picker in the world, but not be able to benefit from that skill because you don't have enough allocation.

5:30So from the extremes, you have people who are like Charlie Munger, who has four positions, all the way to somebody like Tom Gaynor has 250 something, I think. So that's kind of the spectrum. What are your thoughts on either of those extremes? And do you have ways you think are better for average investors? I really like how you said it. And that's roughly kind of the same way I think about it. A 5 % position, for example, and then maybe I have a 1 % or 1.5%. And then what I call skin in the game. Like you said, it's dipping my toe in the water. It's very small. Just want to check it out, see if that encourages me to learn more about, for me, that's a comfortable way to do it.

6:23The way that Charlie does it, I admit when I first got into the whole investing thing, that made a lot of logical sense to me. But then when I started experiencing the joy of picking poorly and making bad investment decisions, I realized that it sounds great on paper. As you get more experience and older, maybe you arrive at that kind of level of concentration. Some people can do it early, more power to them. But I think just the average person, because of the vagaries of investing and the craziness that goes in between our ears that affects so much of what we do, I think being that concentrated is very, very challenging.

7:13I'm not saying that people can't do it, but I would say if you had to look at the broad spectrum of investors, say on the right-hand side, you have that 1.5 % people that can do the Charlie concentration, and then a vast majority of us sit in the middle, and then there's other people that go the Tom Gaynor, Joel Greenblatt, Gardner route of 350 companies in their portfolio. And I think the bottom line is when you're trying to strike, it comes down to what are you comfortable with and what works for you, for your mindset, and how the best way to do it is. And that's kind of what I settle on. And the allocation and the percentages, those help form how many companies to own.

7:58That was the next topic from Ashish. How many companies to own? Well, it depends. If you're 5 % position like Dave, that's 20 companies. 5 % times 20 is 100%. You can't allocate more than 100 % of your portfolio. unless you are using margin or leverage. And we do not, do not, do not ever recommend trying to do that. That is a time bomb waiting to happen. Yeah. So I guess when I'm thinking about investments, I haven't bumped up against this yet, but maybe I will at some point. Like how many is too many? To a certain extent, what Tom Gaynor is doing, 250 companies, there's literally no way he can track all those himself.

8:45And so I wonder about that. I'm not trying to disparage Tom Gaynor because he's obviously, he's him and I'm me. And so I just don't know how they can track that many companies. And so I just wonder, to me, I don't see the benefit of that. But again, I'm not Tom Gaynor and he understands what he's doing. So I, I questioned that. Yeah. I mean, I think it comes down to what game are you trying to play? Like you've said, one of the things that I probably do too much is trying to micromanage my portfolio. As much as we talk about finding great businesses, finding those that compound over a long time period, that means not touching it, right?

9:36Like constantly checking up on every single position is kind of the definition of micromanaging in a way right i mean you're kind of like trust not don't there what is it trust but verify you know right you're kind of doing that but at the same time like it it goes to what kind of businesses are you trying to look at what kind of results are you trying to get are you trying to hit home runs because if if you have 100 stocks and you just need one home run out of those 100 and that's the game you're playing then it really that one stock will carry all the losses and you don't need to micromanage so it's there's so much complexity to that and nuance um but i i i get it i yeah yeah right yep i i get it as well i mean there's a gentleman i follow on twitter or x that he literally owns two companies palantir and robin hood and that's it those are only two companies you know and he picked that two of the most volatile ever.

10:37But that's what he owns and more power to him. I could never do that. As much as I love Berkshire and Visa, for example, I could never just own them. I have to have some other level of diversification to ensure that I'm not wrong. And maybe that's my curse is feeling like I don't know enough. And so by spreading my bets to a certain extent, that helps offset that feeling, if you will. How much money is this gentleman investing into those two? Are we talking about his life savings? Yeah. I mean, well, yeah. I don't know if it's literally his life savings, but everything he invests is in those companies.

11:27I've been following him for four or five years now, so I got to expect it's not a small amount of money. But he hasn't said straight up, this is my life savings. No. No. Okay. So, all right. So, we could be talking about a$200 profit. It could be literally$200. I mean, I literally don't know. I have a lot of problems with that. I just think it's bull crap. like Palantir and Robin Hood. Give me a break. If anybody is following that, then I guess a fool and his money are soon parted. But that is a terrible... This should be an investing show. That's kind of been the idea from the beginning. That is not investing.

12:13That is speculating. Yeah, it's definitely high on the risk tolerance factor for sure. It's not investing. It's not. and neither is putting like half your money in bitcoin either by the way even though people call people like that investors it's not investing it's gambling yes totally agree august is national wellness month but most health trends equal things like buying random gadgets and guessing at what actually works based on whatever's trendy at the time and i wanted to stop guessing at things like that and actually look at the data behind my body i've mentioned it before but lately i've been taking time in the gym much more seriously, not just to build a bunch of, you know, aesthetic muscles, but to build a good, sustainable, long-term health plan for my future.

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15:14Read found fee schedule. What's the best way to get started in the market? Download my ebook for free at stockmarketpdf.com. So what are your thoughts on the whole equal weighting versus weighing per conviction? Yeah, I think again, it kind of comes down to what are you trying to play. I remember we had had a discussion in the past about one of these light bulb moments I had. A lot of quality investors talk about how they want to put the most money into their highest conviction ideas because they're not going to have as many. If you're more like me, more on the numbers side and you look at valuation a lot, that's probably a terrible idea to do because you could argue that some of the stocks with the best valuation discounts can be the most riskiest and might not be.

16:10They might be a high conviction on a numbers basis, but that's not necessarily high conviction on a business performance business. So if you're playing the numbers game, you're playing with probabilities. It doesn't make sense to base your sizing on conviction because you're playing the numbers game. I don't know if I'm making sense, but when you play the numbers game, you're playing that over time, not every stock's going to be a winner, but I'm going to have enough winners because I'm playing, the odds are in my favor. If you kind of mix that with this idea, well, I only get one or two good insights in my life and I'm going to put a bunch of my money in my best idea, that's two different things.

16:56And then I think you can get in a lot of trouble, myself included, when I start to think about which stock to have more conviction and which stock to want to put more money in, it should be more, what's your special insight? What's your special way that you interpret the business quality of this business? And by definition, it should be special. You shouldn't be having these special insights every day. Right. Do you think the way that the style of it that you invest in, i.e. putting$150 in at the beginning of every month, do you think that lends itself more towards maybe not necessarily equal weighting, but maybe more towards that as opposed to air quote using the elephant gun, Warren Buffett, you know, going out and buying big.

17:43Do you think that has a bearing on it as well? Yeah, I think so. Yeah, that's really insightful. The nature of it, of always putting money in, does make the portfolio, if you're trying to balance it out over time, it does turn it sort of equal weighted. Definitely more so than like, because if you have a high conviction on one idea and you try to do that with a dollar cost averaging approach, you're basically just 10 months in a row, you're going to buy the same idea. So to your point, that's not what I'm doing with my newsletter. Not at all. No, not at all. I mean, as much as we would all love to buy Costco 10 months in a row, it's probably not realistic.

18:34So maybe getting back to the portfolio construction for just a minute, when you think about total number of positions, for example, like you were talking about six and a quarter percent or six and a half percent for allocation, if you will. When you, how do you think about like when you start to bump up against, like is there a finite number you feel like, okay, this is enough? Or do you think that it just kind of builds on it for, you know, eternity? Right. Right. For me personally, I'm pretty close to that where it feels like enough. And maybe that's a, what do they call? When you get attached to the stocks you own, there's a bias effect about that.

19:22I'm blanking on what it's called. Yeah, I am too. Not attachment. No. No. If you study psychology and you look at Kahneman's work and things like that, behavioral psychology, there is a literal bias where everybody has different emotions, different brain chemicals about something that they particularly own, something they have an ownership stake in versus not. and so that could be what i'm facing with my portfolio where i feel so good about so much that's in there that i'm not spreading those bets out i have a lot of full positions my full positions make up probably 80 percent of my portfolio right now so you you know take 80 divide by six there's probably 12 13 14 full positions depending on how you define full position that are in there and I find it hard to part with those because I still feel very confident about the long-term prospects.

20:27But again, that could be a bias and that's just what I've come across over the last five years. One of the things I've noticed is that to me, the longer you own a company, the more it feels a little bit like your local sports team or the team that you follow, So football, baseball, basketball, or whatever. You get to know those players because let's say you watch the NBA. And I'll pick on the Timberwolves. You watch the Wolves play 82 games in a season. You get to know all those players very intimately. And you think they're better than they are because you have a familiarity with them. And so sometimes I feel that way about my companies, the companies that are in my portfolio.

21:12Because I've held Visa for five years, I feel like I know that like the back of my hand. And so I worry that if Visa starts to turn for whatever reason, am I going to recognize that? Or is it going to be the bench player on the Timberwolves that, yeah, he's a good player. And I know he's done well in the past. And so I'll keep hanging on to him kind of thing. So that's one of my concerns when I'm thinking about managing the portfolio and how it's constructed and whatnot. So that is definitely, I think, something to keep in mind when you're thinking about all this stuff. Yeah, I love it. I mean, I think it's very wise to have that kind of self-awareness.

22:01And it's a very good thing to have. It'll help you with your investing. Yeah. Yeah. So when you think about diversification, maybe not necessarily versus concentration, but just as a general rule, when you're trying to build, A, build a portfolio and the one you've built, does that really play into, like when you get to 25, 30 companies, do you feel like diversification still impacts your decisions on buying new companies? Or is that something that is maybe more earlier on that needs to be focused on. If I put myself in the shoes of a stock picker, yeah, it's probably something that you care more about as you're building a portfolio out.

22:49Yeah, I would probably agree with that. I think at some point, I think that becomes lesser and lesser of a concern than it does early on. You don't want to have seven payments companies in there out of your 10 portfolio. Right. You want to spread your bets. Yes. All right. So let's talk about maybe some management stuff. So how does buying a new company enter the equation versus holding on to something or adding to an existing portfolio? It's a tricky balance just because, I mean, like for me, I'm always looking at what's in my portfolio. And is there something I couldn't add to? But again, because we're fighting against our emotions, we're fighting against our biases, it's very easy, maybe too easy, to default to that, where if you're never stepping out on a limb to buy something new, then you're just kind of sticking to your group of companies, which is great, especially if you've done a good job picking those companies.

23:54but how long will that last before new types of businesses or new companies that you never had on your radar because you never really cared to look or even take a risk on kind of like the innovators dilemma in a way a lot of tech companies go through this where they have their bread and butter of their business and they want to still make sure that they're doing enough things where they can be aware of whatever trends are out there. I kind of put that mental model on the portfolio management a little bit. Might not be the perfect parallel to that, but if you are too cocooned in your own portfolio, then there's a risk that you are not attuned enough to what's going on outside of the portfolio, which can be missed opportunities.

24:46It could be disruption risks to the companies in your portfolio. So again, I'm not trying to talk in absolutes. I'm just saying there's higher risks because of the emotions involved. And so if you can strike that balance with the intention that this will help me with my emotions and put me on the right path so I have more guardrails, I guess, then yeah, I think it's a good idea to try to have a balance like that. Yeah, I agree with that. And that's something that I know I struggle with is that Peter Lynch idea that he mentioned about sometimes the best idea is the one you already own. And that, unfortunately, is stuck on permanent loop in my head.

25:37And so sometimes when I'm thinking about, do I buy something new or do I add to what I have, that I have to fight against that permanent loop of, you know, Peter Lynch said, Peter Lynch said, Peter Lynch said. I'll help you break it. You want me to break it for you? I'm going to take a sledgehammer and just smash it down. Smash it to bits? Yeah. Peter Lynch held stocks for, on average, a year and a half. Yeah. It's a very good point. And he also had a gazillion of them too, didn't he? He did, yeah. And he would buy something, it would skyrocket, he'd buy a little more and then he'd be out in six months.

26:16Right. That's a very good point. So it's ironic that I have that on permanent loop in my head, but yet the person who stated it did not follow that advice in any way, shape, or form. That's funny. Thank you for taking the sledgehammer. that's very helpful. You're welcome. Bitcoin is one of those really divisive topics. And depending on where you stand on it, either you ignore it or you can see its future utility and the things it powers. And so in a time like today, we're all wondering how much exposure makes sense and how can I get that exposure in a simple and easy way? Where you aren't subject to countless fees, endless passwords, and constant micromanaging with too much time spent on websites and apps.

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28:14All right. So I guess kind of moving past that, how do you think about the timing of the companies you own? So the question is when to trim versus let your profits run. So to me, that's like, when do you trim versus the Charlie Munger idea of not interrupting the pounding? Yeah, 100%. How do you balance that? I go back to the thing that you and I have been preaching for years and years and years ever since Gilbert put this in repeat in my head. If you're a long-term investor like Dave and I, when do you sell stock when the fundamentals of the business have changed? so if you're buying these stocks and intending to hold them for years and years and years and years then profits are a good thing profits are evidence that the company is growing you don't have to take those off the table because if you're a business owner it's just evidence that the company is growing and if you think it's going to continue to grow then don't worry there will be more profits you don't have to take them now i think that kind of mindset sounds simple sounds easy it's not easy but trying to remind ourselves of that.

29:22Because if you focus on the business rather than the stock, then you can analyze, okay, maybe the business has changed. Maybe the recent struggles and the stock price going down is because everybody's figuring out that this company, their glory days of 10 years ago are no longer. That's a good reason to sell. But to sell because the stock's up 300 % and I want to lock that in, not always a great idea especially if you're investing the way we are no no exactly something i i don't remember who said this but one of the ways to achieve an idea like a 10 bagger for example is you got to hold on to the company long enough for to actually achieve that so it's easy to say that you're a long-term investor it's easy to say i want 10 baggers or i want 100 baggers or a five bagger or whatever it's easy to say those things, but to do it, you actually have to hold on to the business.

30:20And I think the key point that you said in that is when you analyze the business and disassociate that from the stock price, it becomes easier to look at what's really going on with a company because sometimes the price volatility can shade our thinking. And if we can remove that from the equation, it becomes easier to go, okay, to your point, are there glory days in the past? And maybe I didn't notice that because the stock price kept going up and now all of a sudden now it's not. And the rest of the market is catching on and maybe you're a little slow to the punch. So that could be the issue.