Thursday, July 22, 2010

Number of Companies in an Individual’s Portfolio ?

This is one question that almost all long term investors ask themselves. Most of the well known value investors that we read about in public domain, usually, are concentrated in teens. If that’s the case, then what about diversification? The concept of risk is very subjective because every person will have a different risk profile. These well known value investors have proficiency to balance risk vs. returns. They have resources to be able to manage that risk of concentration. As individual investors, we do not have such resources at our disposal, and hence risk level changes for us. In addition, we cannot generalize that a fixed “number of stocks” provides diversification.

Being a dividend investors, I am looking for companies that have potential to grow their dividends over time. I have observed that companies that grow their dividends, with good quality of earnings, the market value (or share price) also grows. This not only provides dividend cash flow, but also the capital appreciation over time.

Now, in case of concentrating the portfolio to small number of stocks will increase my risk. Assuming equal allocation in 10 companies, when any one company suspends dividends, it will reduce my dividend cash flow by 10%. That is a very large drop. Therefore, I am targeting to build my portfolio with 30 to 35 companies.
  • The reason for using 30 to 35 companies is that I want to limit the risk if dividend cash flow to any single company to maximum of 5%. In one my earlier post, I have discussed the process of risk management.
  • It would be a folly to expect that all companies in the portfolio would continue to pay growing dividends. 100% success rate is purely an illusion. However, I would expect that at a minimum there would always be 20 to 25 companies performing as per my initial expectation. These will continue to provide growing dividends over time. I also expect that they will continue to increase their value.
  • The remaining ones may or may not perform. I will have to continue to make changes such as adding to existing ones, removing, and adding newer ones.
  • In addition, I also understand my limitation of not being able to keep track of more companies.

At present, I continue to hold approximately 27 companies. One of the benefit of long term buy and hold investing is that you do not need to keep following the market daily or monthly; all of the companies that I select are not going to vanish or crash in such short period of time. Sure, some small number will have problems like 2008/2009, but I do not expect to have all of them in a same crashing bucket. If it does happen, then it was likely due to improper portfolio management process.


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