I use a rigorous, analytical approach to determine the values a businessman would place on the businesses that I buy for my clients. In my view, the most important factor in purchasing a stock is the price paid in relation to the intrinsic value of the stock. My approach is to attempt to buy each stock well below its intrinsic value. By doing this with twenty-five to thirty-five well-diversified stocks, I hope to put the odds of success in my client's favor.
All of my clients' stock portfolios consist of between 25-35 stocks. Academic studies have determined that holding 18-20 stocks will supply 95% of the diversification as a portfolio with 100 stocks. In my view, mutual funds that hold 100 or more stocks have very little chance of outperforming the indexes over the long run. With twenty-five stocks, if I make a good selection then the portfolio will benefit significantly from it. When a stock is only 1% of the entire portfolio, even if it doubles, it will add only a 1% gain to the portfolio's overall return.
A portfolio manager that buys one hundred stocks is admitting that he cannot distinguish which of the 100 stocks is more desirable than the other 99. Of course, to take this argument to its logical extreme would require that the entire portfolio be invested in one stock. If one was certain that one stock would outperform the others it would be foolish to buy the other stocks and dilute the overall return. Since one can never be that certain about the prospects of one stock, I have found that a portfolio of twenty-five to thirty-five stocks provides the best balance between these two contradictory concepts. I do attempt to diversify among different sectors where the business risks are opposed to each other. In other words, I would not buy ten housing stocks or ten drug stocks even if they represented the best sectors to buy.
Unlike some mutual funds and investment advisors, I do not use options or other derivatives to hedge my client's portfolios. This is not a hedge fund and no shorting of stocks is allowed. My only risk management tools are being sure that I do not overpay for stocks and going to a maximum cash position of 50% if I am unable to find good values in the stock market.
Another key part of my risk management strategy is active portfolio management. In volatile markets if one fails to lock in significant gains it will be difficult to outperform the benchmark over time. While the turnover rate will vary depending on market conditions, one can expect a 100-150% turnover rate. My nontaxable accounts will be a little more actively managed since no taxes are imposed on the gains.