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StockCentral :: Community
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Join in on the discussion with other like-minded investors in our community forums. Learn about the fundamental investing methodology and participate in educational workshops in the Investing forums, stay up-to-date on StockCentral news and make suggestions to the StockCentral team in Central Square, and discuss your favorite stock or recent market news in our A-Z ticker-based forums.
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Doug Gerlach
Cambridge, MA
http://www.iclub.com/
President, ICLUBcentral
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| 02/22/2007 10:50 PM |
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Now we're going to really start looking at our portfolios using some of the information that you've collected, starting with the diversification of your holdings.
If we were all as smart and as astute an investor as Warren Buffet, we'd follow his advice and buy just one stock -- and hold it forever. For most of us, though, it's hard to imagine the level of research and commitment that would go into making a decision like that. Many folks wouldn't sleep so well at night knowing that their entire wealth was tied to the performance of just one stock.
As a result, most investors don't buy a single stock with their available cash, but instead buy several different stocks, hoping to minimize the impact of problems that might arise in a single company. If one stock in your portfolio plummets in price for any reason, you've got several other stocks that might still plod along on the growth highway. Academic research has recently suggested that the fullest benefits of diversification come from owning 15 to 20 stocks (which is a bit higher than the common wisdom of a decade ago that held that 12 to 15 stocks were necessary to be properly diversified). But you'll have to decide how many stocks that you or your club can effectively follow and manage on your own. It's far better to own fewer stocks and be able to devote enough attention to them to understand what's going on in each company than trying to follow too many companies. In addition, if you own too many stocks, approaching 100 and up, you lose the benefits of investing in a well-chosen portfolio of high-quality individual stocks and your returns will start to diminish back towards the average of the overall market. In other words, owning too many stocks lessens the likelihood of beating the market.
But it's not enough to simply buy a handful of stocks. You also need to diversify your portfolio by buying companies in several different industries, as well as companies that are both small and large.
As many investors learned when the tech bubble burst in 2000, being over-weighted in a single sector can be disastrous. Diversifying by industry helps minimize the risk in a portfolio by isolating the damage that might be caused by industry-wide problems. If a problem affects a particular industry, companies in other industries may be less likely to be affected. A parts shortage that affects computer makers won't have much impact on sales at grocery stores, for example.
The other important consideration in examining the diversification of your portfolio is whether or not you own a good mix of small, mid-sized, and large companies. Spreading out your investments among companies of all sizes brings some benefit since these different categories tend to fall in and out of favor with investors at different points in the bull and bear cycle. In particular, small and large companies tend to have a high degree of non-correlation, which is to say that when large company stocks are doing well, small company stocks are not. And vice versa.
The other rationale for owning companies of all sizes is that smaller companies tend to grow more rapidly, but they're generally less consistent than larger companies. Larger companies tend to be more stable and pay dividends, but their growth will be slower than small companies. And mid-sized companies, as you'd expect, can grow moderately quickly with reasonable levels of consistency.
It's important to note that company size is not measured by market capitalization, which is often not much more than a measure of how much investors love a particular stock, but by looking at the annual revenues. A small company is defined as having annual revenues below $500 million; a large company has revenues over $5 billion; mid-sized companies are in between.
This brings us to our day #3 task:
3. Determine the diversification of your portfolio.
We'll start with how many stocks you own. Do you have too many stocks? Or too few?
Next, let's look at the target diversification by company size. Mid-sized companies should make up the largest single portion of your portfolio. About 50% of all of your holdings should be mid-sized companies. About 25% of your portfolio should be directed to small company stocks, and 25% to large company stocks.
For many investors, this is a challenge, since they discover that their portfolios are heavily over-weighted in large company stocks. This is natural, since we tend to invest in companies that we know and understand, household names and brands, businesses that we frequent on a regular basis. But the growth that comes from these stocks just isn't enough to justify the inherent risks of the stock market. We need more growth and that comes from thinking small.
How much of your portfolio is invested in small, mid-sized, and large companies? You can use the worksheet from Day #2 to help you tally up the percentages.
Then, move on to considering the diversification of your portfolio by sector and industry. Ideally, a 15-20 stock portfolio would include companies in 6 or more different sectors, and in different industries within those sectors. Diversifying by industry doesn't mean buying stocks in seven industries in the healthcare sector. You need to venture into services, industrial goods, technology, etc. (Here's a tip: See the Data section on the FAQ page of StockCentral for a listing of all the sectors and industry groups we use.) How many different sectors and industries are in your portfolio? And are your investments spread out fairly evenly or are they lopsided?
This information you gather from studying the diversification of your portfolio should really serve as a guideline for future decisions. For most people, I don't believe that you need to take immediate action to sell a bunch of stocks if you determine that own too many large companies or have too much invested in technology. Instead, use this information to help you when it comes time to consider new ideas, or make purchases of new stocks or add to current holdings. You might use a stock screener to search for smaller companies for your next purchases. Or you might decide that since you're over-weighted in technology stocks, you'll transfer one of them to a departing member in your club. Or maybe you'll be a bit quicker to sell an underperforming large company knowing that you've already got too many big stocks in your portfolio.
Perhaps you should even make some resolutions about how you'd like to improve the diversification of your portfolio. Write down where you're currently strong and where you're weak, just as a reminder when you make your next portfolio purchase.
Diversification targets are always moving, so you'll never reach that state of perfect balance. But knowing where you stand right now can give you important tips on where you should be headed in the future.
Doug |
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Posting from ICLUBcentral world headquarters in the Harvard Square's historic College House, Cambridge, MA
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Bonnie MacPherson
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| 02/22/2007 11:45 PM |
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Doug,
This 10 day class is a wonderful "checkup" tool for those of us who are beginning to get a little "set in our ways" or just "stale". My husband and I had started a more thorough analysis = "weeding and feeding" of our portfolio= and this Classroom topic is just what we needed to give us the extra "oomph" to do the job more effectively. Thanks for all your hard work. And like Randy, "when do you sleep??".
Bonnie MacP |
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Dave Adams
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| 02/23/2007 12:24 AM |
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I can say beyond a doubt, as someone who is getting into investing "again, for the first time.", this is an awesome tool! I am all over this class. I was hanging on Day 3 to get posted! I just received (2 days ago) the Take Stock book that so many have recommended to me, and have been in that when possible. I am having a ball!
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Dan Hess
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| 02/23/2007 10:12 AM |
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Doug
First let me thank you for providing this learning experience on building a better portfolio. I agree with your suggestions on diversification and have one additional question.
For quite a few years value stocks have been out performing growth stocks. The use of the SSG seems to influence users to accumulate growth stocks rather than value stocks. Over time the performance of value vs growth will likely equal out but there can be long periods like the recent years where one (in this case value) outperforms. Thus it would seem prudent to also diversify between value and growth classifications. I do recognize this may be a little more difficult since some companies fall into a gray area between growth and value. For example Home Depot has long been a growth stock, but now approaching new store saturation and slowing same store sales it is shifting towards value. Morningstar now classifies HD as Core, somewhere between growth and value.
What is your view and pros and cons of also diversifying by growth versus value?
Thanks again for the superb learning experience.
Dan Hess
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Doug Gerlach
Cambridge, MA
http://www.iclub.com/
President, ICLUBcentral
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| 02/28/2007 4:01 PM |
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Posted By Dan Hess on 02/23/2007 10:12 AM For quite a few years value stocks have been out performing growth stocks. The use of the SSG seems to influence users to accumulate growth stocks rather than value stocks. Over time the performance of value vs growth will likely equal out but there can be long periods like the recent years where one (in this case value) outperforms. Thus it would seem prudent to also diversify between value and growth classifications. I do recognize this may be a little more difficult since some companies fall into a gray area between growth and value. For example Home Depot has long been a growth stock, but now approaching new store saturation and slowing same store sales it is shifting towards value. Morningstar now classifies HD as Core, somewhere between growth and value.
What is your view and pros and cons of also diversifying by growth versus value?
Part of the problem is the conflicting results of academic research into the topic. According to Ibbotson, the Russell 1000 Value Index generated 1% more in compound annual return than the Russell 1000 Growth Index in the period from 1979 to 1997, and that the value index exhibited a standard deviation in annual return substantially less than the growth index. That's not chump change and would tend to suggest that value is superior over growth in general.
However, in "Common Sense on Mutual Funds," John C. Bogle wrote that from 1973 to 1992, growth funds grew 10.1% a year on average, while value funds grew 11.0%. But over the 60 years from 1937 to 1997, growth funds returned an average of 11.7%, while value funds returned 11.5%. In his findings, there was no significant difference between the two.
In 2002, Bogle updated his position and conceded that if you considered the indices, it was indeed true that value indices appeared to trump growth indices over the long-term. But he then pointed out that his conclusions as published in his book still held true -- that when you considered managed funds there was no significant difference between returns based on style.
The consulting firm McKinsey in February 2007 produced an interesting study in February 2007 called "The Truth About Growth and Value Stocks" in which they discovered that, in general, the revenues of growth stocks and value stocks grow at the same rate. For growth stock investors, that's certainly an interesting development -- since growth stock investors bank on a company's ongoing growth to fuel profits and eventually drive their stock's price. If you look back at the 1990s, you might not be so surprised to learn that Philip Morris was one of the most widely held stocks in both growth and value funds.
While there is some evidence of a fairly high level of non-correlation between value and growth styles on an annualized basis, Bogle's book includes some data on the five-year returns of each style for the 73-92 timeframe in which there isn't a large degree of non-correlation. In other words, in each of those periods, value or growth will outperform the other by a bit, but they both are heading in the same direction. If growth is up for the year, so is value, and vice versa.
In the end, the debate will probably continue to rage. I don't see it as a slam-dunk that choosing to diversify by style has a lot to offer over a single consistent and well-executed investing approach.
Doug
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Posting from ICLUBcentral world headquarters in the Harvard Square's historic College House, Cambridge, MA
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Michael Higgs
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| 02/28/2007 10:32 PM |
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Posted By Doug Gerlach on 02/22/2007 10:50 PM
This information you gather from studying the diversification of your portfolio should really serve as a guideline for future decisions. For most people, I don't believe that you need to take immediate action to sell a bunch of stocks if you determine that own too many large companies or have too much invested in technology.
It seems to me diversifying by capitalization is irrelevant. Start from the position of buying the best companies (based on how you define best) when they are cheap and holding them until they are expensive or the selection fundamentals that you used to purchase the stock change. If that leads you to a portfolio dominated by large caps, it doesn't matter if your selection criteria are being met and you weed and feed on a timely and consistent basis.
Regards,
Mike
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Laura Scott
Florida
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| 03/01/2007 2:57 PM |
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Thanks Doug for putting together this classroom! I desperately need it. I'm coming in late, but will be playing "catch-up". I've always needed to weed and feed my portfolio and learn how to better manage it. This is excellent! Thanks again.
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Doug Gerlach
Cambridge, MA
http://www.iclub.com/
President, ICLUBcentral
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| 03/01/2007 3:14 PM |
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Posted By Michael Higgs on 02/28/2007 10:32 PM
It seems to me diversifying by capitalization is irrelevant. Start from the position of buying the best companies (based on how you define best) when they are cheap and holding them until they are expensive or the selection fundamentals that you used to purchase the stock change. If that leads you to a portfolio dominated by large caps, it doesn't matter if your selection criteria are being met and you weed and feed on a timely and consistent basis.
I agree that diversifying by capitalization is irrelevant. Instead, we prefer to categorize companies by the size of their revenues. Capitalization can be misleading since small companies can often have large capitalizations based on nothing more that irrational investors.
Buying only large company stocks may be your preference, but it locks you into more slowly growing companies and forces you to look for opportunities that are more of the "fallen angel" variety in order to generate an acceptable return. In other words, in looking for good companies that are cheap, they'll have to be very cheap -- and therefore probably have some significant problems that may be more than temporary -- before they can priced at a point that will generate a market-beating return. When looking at faster growing small and mid-sized stocks, you can buy reasonably priced stocks, hold onto them, and realize your target return, without worrying if the company will turn around. Of course, many people shy away from smaller companies because of the risk, but that's why a good mix of companies by size, primarily focused on mid-sized stocks, works for most investors and clubs.
Another reason to own both small and large companies, although somewhat less important for long-term investors, is that they display a significant level of non-correlation -- when small companies do well, large companies tend to not perform so well, and vice versa.
Of course, in the end, every investor gets to decide how best to invest his or her dollars into the stock market -- so you can certainly refine your guidelines. But I certainly wouldn't advocate a strategy of investing only in blue chips for someone who wanted a growth stock portfolio.
Doug |
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Posting from ICLUBcentral world headquarters in the Harvard Square's historic College House, Cambridge, MA
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Michael Higgs
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| 03/01/2007 4:46 PM |
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Posted By Doug Gerlach on 03/01/2007 3:14 PM
I agree that diversifying by capitalization is irrelevant. Instead, we prefer to categorize companies by the size of their revenues. Capitalization can be misleading since small companies can often have large capitalizations based on nothing more that irrational investors.
Buying only large company stocks may be your preference, but it locks you into more slowly growing companies and forces you to look for opportunities that are more of the "fallen angel" variety in order to generate an acceptable return. In other words, in looking for good companies that are cheap, they'll have to be very cheap -- and therefore probably have some significant problems that may be more than temporary -- before they can priced at a point that will generate a market-beating return. When looking at faster growing small and mid-sized stocks, you can buy reasonably priced stocks, hold onto them, and realize your target return, without worrying if the company will turn around. Of course, many people shy away from smaller companies because of the risk, but that's why a good mix of companies by size, primarily focused on mid-sized stocks, works for most investors and clubs.
Another reason to own both small and large companies, although somewhat less important for long-term investors, is that they display a significant level of non-correlation -- when small companies do well, large companies tend to not perform so well, and vice versa.
Of course, in the end, every investor gets to decide how best to invest his or her dollars into the stock market -- so you can certainly refine your guidelines. But I certainly wouldn't advocate a strategy of investing only in blue chips for someone who wanted a growth stock portfolio.
Doug
I agree that revenues rather than capitalization is a better way to determine size. But I'd still say that you start with your criteria first. For example, if I want 15% annual growth over 10-yr., 5-yr., and 3-yr. time frames; a strong balance sheet with debt/equity < 50%; and 10-yr R^2 > .8, Prospector finds 85 stocks of which 10 have sales greater than 10 billion. The mix of cheap small, medium and large companies will tend to vary with the economic cycle.
Regards,
Mike |
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LOWELL HERR
https://home.comcast.net/~LowellHerr/index.html
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| 03/08/2007 11:09 PM |
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"Personally, I think that it's more important to focus on a single style and be consistent in your investing approach instead of diversifying by investment style. I don't think the case is very strong for attempting to diversify a portfolio by investing in both growth and value stocks."
Doug,
If it works, I am attaching a spreadsheet showing the performance of eight major asset classes from 1989 through 2006. For this time period, one can see that value outperforms growth.
Lowell Herr
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 Attachment: AssetClassPerformance-December 29-2006.xls
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Joe Craig
Ellicott City, MD
StockCentral Administrator
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| 03/08/2007 11:15 PM |
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> Is it possible to attach files to these messages.
Yes it is. When you are in the editor, scroll all the way down to the bottom to find the area where you can attach files. You can attach 3 files to each message. |
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Joe |
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Michael Higgs
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| 03/14/2007 7:49 AM |
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Posted By LOWELL HERR on 03/08/2007 11:58 PM
The use of the SSG seems to influence users to accumulate growth stocks rather than value stocks.
I think that it's more the NAIC rather than the SSG. I'm basically a dividend growth value investor and yet I use the SSG approach exclusively. It lead me to buy stocks such as INTC and MSFT when they became extremely cheap. I'll continue to hold them as long as I believe that the dividend growth is sustainable and that growth exceeds inflation.
Regards,
Mike |
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