Friday, July 11, 2014

Why You Should Probably Own Fewer Stocks

I think the average person could know three or four or five companies very well. They could lecture on those three or four or five companies, and if one or two of 'em becomes attractive, they buy 'em...You have to know the story. - Peter Lynch 
Pardon the Saved by the Bell reference. Couldn't resist.
For many individual investors, finding the time to do proper research is a real challenge. After higher-priority commitments to family, friends, work, etc., if you have time to read one annual report a week, you're doing pretty well. 

In my experience, an investor doing all the work himself or herself needs between five to ten hours a year to keep good tabs on each stock they already own -- i.e. reading quarterly reports, the annual report, conference call transcripts, etc. Thoroughly researching a brand new stock typically takes over ten hours.

So, how much time do you have to dedicate to stock research? With 50 hours a year to spare -- about an hour a week -- you might be able to cover ten companies, but it's likely fewer. If you can outsource some research to a reliable newsletter or research service, then perhaps a few more. 

The important thing is to maximize the returns on your research time. In other words, make sure you're giving each holding the appropriate amount of research time and make sure you're investing enough in each idea that it's worth the time you're spending on it.

To illustrate, I recently reviewed my own portfolio and concluded that I owned more companies than I could adequately cover in my spare time. In addition, I had a number of 2% or 3% positions that weren't likely to have a major impact on my returns, even if they did very well.

With the market still riding high, it seemed like an ideal opportunity to go through my portfolio and eliminate smaller holdings. I started by asking myself the following questions for each stock I own:

  • Did you read the company's latest annual report/10-K?
  • Did you vote your shares and read the annual proxy statement?
  • Is the company's competitive position getting better or worse?
  • Where is the company in its business cycle?
  • What was the company's last major capital allocation decision (M&A, special dividend, etc.)?

  • If I answered "no" or "I don't know" to at least one of the above questions, it was clear that I wasn't thinking about my investment like a part-owner of the business. Either I needed to re-commit to researching the company or it was time to sell the position.

    There are a number of clear benefits to owning a smaller, more manageable number of stocks. For one, you'll have fewer holdings set on autopilot, more time to focus on your best ideas, and more money to put behind your best ideas.
    You might even realize better performance. A 2008 study by Ivkovic, Sialm, and Weisbenner found the following:
    Among households with portfolios large enough to diversify among many stocks, if desired, the holdings and trades made by those focusing their attention on a few securities tend to perform significantly better than the investments made by those diversifying across many stocks.
    Diversification is important, of course, but much of your core diversification needs can be met through low-cost index funds and ETFs. For the portion of your portfolio directly invested in stocks, however, it's important to have sufficient time and resources to monitor each company and make the most of the research time you have.

    What do you think? Let me know in the comments below or on Twitter @toddwenning.

    What I've been reading this week:
    Stay patient, stay focused.