Concentrated Portfolio.
If you read any book about investing, you will be quick to see a common method of limiting loss in the market: DIVERSIFY!
Having a diverse portfolio is important. When you hold multiple positions you bet that of your stock picks, you will have over half your positions be winners. The logic is that out of say 5 companies, if 3 are winners, they should be enough to cancel out your other 2 losers and still leave you with capital gains (profit!). This limits your risk effectively in larger portfolios by diversifying the non systematic risk factors.
At MoneyJog.com, we currently recommend a Concentrated Portfolio or a portfolio with only one or two positions over a well diversified portfolio. Now there is logic behind our concentrated portfolio approach. Consider this scenario:
You have $2,000 to invest (Congrats! That’s a good starting amount!). Each trade costs $10. (ie, to buy stock there is a service cost of $10). to sell a position also costs $10. To have an effectively diversified portfolio, you need roughly five stocks. At $2,000 this means you would have 5 positions at $390 (evenly weighted). Now how much does that $390 buy? Not much when quality stocks are 40-100’s of dollars a share ($390 will buy 19 shares of a $20 stock). With 5 stocks in your portfolio, it will cost $50 in fees to change your positions/holdings. It is expensive for you to protect your money this way if you find yourself needing to sell out of positions/holdings.
If you have been following along, you would see that the 5 positions at $390 is not equal to your first $2,000. This is because you paid out $50 in fees to your broker or trade engine.
$2000÷5 = $400 Less: $10×5 = $50 in fees … ($2000-$50)÷5 = $390 weighted evenly among your 5 companies
So here we decide to break the golden rule in order to save on trading fees and to maximize gains. It’s much easier to cover your $20 round trade fee if you have 100 shares of XYZ versus if you only have 20 XYZ.
Our basic rule of thumb for diversity in portfolios is at least $2,000 to a position. This gives you ample purchasing power to effectively make money and cover fees. Remember that 200 XYZ covers trading fees faster than a portfolio of 90 XYZ and 90 ABC, which has (1) less shares, thus less purchasing power and (2) double the trading fees.
Concentrating our positions reduces our trading costs ($10 dollar trades add up fast!) and expands our purchasing power in a position. A result of having a more concentrated portfolio, is that we are more susceptible to risk. This is because with a concentrated portfolio you do not have other positions to possibly cancel out any losers with other winners. The goal, sweet and simple: Find companies that are most likely expected to increase in value, and trade in these names. Because we lean towards a more concentrated portfolio strategy, we will not accept heavy or large losses in our portfolio to protect our bottom line and to help reduce risk to an extent. It is better to have lost $80, than to lose $300 (true). So if the tide of markets shall turn on us, we will minimize our losses quickly (using limit orders or better judgement). One last example will emphasize the discussion.
Consider the following in a portfolio of XYZ:
400 shares of XYZ 75 shares of XYZ
XYZ increases by 15 cents.
400 x $0.15 = $60 75 x $0.15 = $11.25
LESS: Trading fees…
$60 – $40= $40 (Gain) $11.25 – $40 = -$28.75 (Loss)
Wow! That loss is MORE than what the fees were on the stock. Good job buddy… at that rate you’ll bankrupt your portfolio after changing your positions 14 times!!
You may have noticed that the trading fees in the previous example total $40, and not $20 like we discussed earlier. It costs $10 to buy and $10 to sell (10+10=20 right?). But after you have sold your position you need to buy into another position, whose round trade cost is (10+10) $20.
So 20+20 = 40 and this 40 is your golden number to making money in the stock market. Any gains over $40 are pure gains for you to keep! Realistically you could say anything over $20 covers the fee’s for THAT trade. By using $40 instead of 20, we are setting the bar a tad higher to be more cost efficient, as the trading fee’s to buy back in would already be covered from your earlier gains. This may seem a little bit confusing but simply put, aim to make at least $40 off any trade.
Now I in no way mean to say diversity is not important! Diversity is very important in much larger portfolios, but when we have less money to use (such as the average beginning investor) it’s under theory, responsible NOT to diversify in an effort to reduce your trading fee expenses and to potentially maximize capital gains from trading.