Now that you've learned how to analyze companies and pick stocks, it is time to focus on putting groups of stocks together to construct your stock portfolio. While Nobel prizes have been awarded and entire books written about this topic, we'll try to briefly summarize the academic theory and focus on some of the more important aspects of portfolio management.

Though we will supply some guidance, no one answer is right for everyone when it comes to portfolio construction. It's more art than science. And perhaps that's why many believe portfolio management may be the difference that separates a great investor from an average mutual fund manager. Famed international stock-picker John Templeton has often said that he's right about his stock picks only about 60% of the time. Nevertheless, he has accumulated one of the best track records in the business. That's because great managers have a tendency to have more money invested in their big winners and less in their losers.

While we don't own any secret recipe to be able to tell you which stocks will be the big winners in your portfolio, we can guide you in deciding how many stocks you may need to own and some other considerations.

The Fat-Pitch Approach

In Lesson 405, we introduced you to the concept of the fat-pitch approach. We noted that you should hold relatively few great companies, purchased at a large margin of safety, and that you shouldn't be afraid to hold cash when you can't find good stocks to buy. But why?

The more stocks you hold, the lower your chances of underperforming the market. Of course, the more stocks you hold, the lower your chances of outperforming the market, but your portfolio is less risky. So the key question to ask yourself is: "Why do I invest in individual stocks at all?"

If the answer is that you think you can do better than a mutual fund, then you should hold a fairly concentrated portfolio of stocks because that gives you the highest odds of outperforming the averages. By "fairly concentrated," we mean 12 to 20 stocks.

As we previously noted, most investors will discover only a few good ideas in any given year--maybe five or six, sometimes a few more. Investors who hold more than 20 stocks at a time are often buying shares of companies they don't know much about, and then diversifying away the risk by holding lots of different names. It's tough to stray very far from the average return when you hold that many stocks, unless you have wacky weightings like 10% of your portfolio in one stock and 2% in each of the other 45.

What Do the Academics Say?

While we as stock investors question many aspects of modern portfolio theory, we do believe it contains some important frameworks that may help you to feel comfortable when investing in a concentrated portfolio. One of them involves the two ways to define risk:

Unsystematic risk is the unique risk of the company or stock that can be offset through diversification. Think of this as risk specific to a company, such as poor management, eroding profits, or a product recall.

Systematic risk is the market risk that cannot be diversified. This is the risk that affects the valuation of all stocks

Academics have proved that of your total risk, you can diversify away your unsystematic risk. The larger the number of stocks you own, the more diversified you are, and the less unsystematic risk that you incur. For instance, if the profits of one of your companies are falling below expectations, and if you hold a large number of stocks, chances are another company in your portfolio is exceeding expectations.

There is some risk that you can't diversify away, the systematic risk. You cannot eliminate the risk from the macroeconomic factors that affect all stocks. So even if you own 1,000 stocks, you will not diversify away the inherent risk of owning stocks.

How Many Stocks Diversify Unsystematic Risk?

Once you own a certain number of stocks, you have eliminated all the unsystematic risk. When you have reached this point, there is no need to own any more stocks to diversify your risk of concentration, that is, the unique risks associated with any one stock. So how many stocks do you need to own to reach that point?

Let's hear from the experts. In their book Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown reported that in one set of studies for randomly selected stocks, "…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks." In other words, if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.

Essentially, the theory says that if you are properly diversified, on average, you will get the same return in the market as if you had bought a passive market index. So if you want to obtain a higher return than the markets, you increase your chances by being less diversified. At the same time, you also increase your risk.

It is also important to note that if you own more than 18 stocks, you will have achieved almost full diversification, but now you will just have to keep track of more stocks in your portfolio for not much marginal benefit.

While much of academia has focused on the risk of not being diversified enough, we believe that there's a practical risk to being too diversified. When you own too many companies, it becomes nearly impossible to know your companies really well. Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the 10-K, skip on investigating the firm's second competitor, and so on. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor. Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.

Non-Market Risk and a Concentrated Portfolio

Interestingly, holding a concentrated portfolio is not as risky as one may think. Just holding two stocks instead of one eliminates 46% of your unsystematic risk. Using a twist on the 80/20 rule of thumb, holding only eight stocks will eliminate about 81% of your diversifiable risk.

What about range of returns? Joel Greenblatt in his book You Can Be a Stock Market Geniusexplains that during one period that he examined, the average return of the stock market was about 10% and statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between negative 8% and positive 28% about two thirds of the time. That means that one third of the time, the returns fell outside this 36-point range.

Interestingly, Greenblatt noted that if your portfolio is limited to only five stocks, the expected return remains 10%, but your one-year range expands to between negative 11% and positive 31% about two thirds of the time. If there are eight stocks, the range is between negative 10% and positive 30%. In other words, it takes fewer stocks to diversify a portfolio than one might intuitively think.

Portfolio Weighting

In addition to knowing how many stocks to own in your portfolio and which stocks to buy, the percentage of your portfolio occupied by each stock is just as important. Unfortunately, the science and academics behind this important topic are scarce, and therefore, portfolio weighting is, again, more art than science.

We do know that the great money managers have a knack for having a greater percentage of their money in stocks that do well and a lesser amount in their bad picks. So how do they do it?

Essentially, a portfolio should be weighted in direct proportion to how much confidence you have in each pick. If you have a lot of confidence in the long-term outlook and the valuation of a stock, then it should be weighted more heavily than a stock you may be taking a flier on.
 
If a stock has a 10% weighting in your portfolio, then a 20% change in its price will move your overall portfolio 2%. If a stock has only a 3% weighting, a 20% price change has only a 0.6% effect on your portfolio. Weight your portfolio wisely. Don't be too afraid to have some big weightings, but be certain that the highest-weighted stocks are the ones you feel the most confident about. And of course, don't go off the deep end by having, for example, 50% of your portfolio in a single stock.

Portfolio Turnover

If you follow the fat-pitch method, you won't trade very often. Wide-moat companies selling at a discount are rare, so when you find one, you should pounce. Over the years, a wide-moat company will generate returns on capital higher than its cost of capital, creating value for shareholders. This shareholder value translates into a higher stock price over time.

If you sell after making a small profit, you might not get another chance to buy the stock, or a similar high-quality stock, for a long time. For this reason, it's irrational to quickly move in and out of wide-moat stocks and incur capital gains taxes and transaction costs. Your results, after taxes and trading expenses, likely won't be any better and may be worse. That's why many of the great long-term investors display low turnover in their portfolios. They've learned to let their winners run and to think like owners, not traders.

Circle of Competence and Sector Concentration

If you are investing within your circle of competence, then your stock selections will gravitate toward certain sectors and investment styles. Maybe you work in the medical field and thus are familiar with and own a number of pharmaceutical and biotechnology stocks. Or perhaps you've been educated in the Warren Buffett school of investing and cling to entrenched, easy-to-understand businesses such as Coca-Cola KO and Wrigley WWY.

Following the fat-pitch strategy, you will naturally be overweight in some areas you know well and have found an abundance of good businesses. Likewise, you may avoid other areas where you don't know much or find it difficult to locate good businesses.

However, if all your stocks are in one sector, you may want to think about the effects that could have on your portfolio. For instance, you probably wouldn't want all of your investments to be in unattractive areas such as the airline or auto industry.

Adding Mutual Funds to a Stock Portfolio

In-the-know investors buy stocks. Those less-in-the-know, or those who choose to know less, own mutual funds. At least that's the rap when it comes to the stocks versus funds issue.

But investing doesn't have to be a choice between investing directly in stocks or indirectly through mutual funds. Investors can--and many should--do both. The trick is determining how your portfolio can benefit most from each type of investment. Figuring out your appropriate stock/fund mix is (you knew this was coming) up to you.

Begin by looking for gaps in your portfolio and circle of competence. Do you have any foreign exposure? Do your assets cluster in particular sectors or style-box positions? Consider investing in mutual funds to gain exposure to countries and sectors that your portfolio currently lacks.

Some funds invest in micro-caps, others invest around the globe, still others focus on markets, such as real estate, that have their own quirks. Stock investors who turn over some of their dollars to an expert in these areas gain exposure to new opportunities without having to learn a whole new set of analytical skills.

For example, there are several ways to invest internationally:

• Purchase U.S. stocks like Wrigley and Coca-Cola that have extensive international operations.
• Purchase international stocks that have U.S. listings or ADRs such as Cadbury Schweppes CSG and Unilever UL.
• Purchase international stocks on a foreign exchange.
• Own an international equity mutual fund.

Ultimately, your choice depends on your circle of competence and comfort level. While many may feel comfortable with picking their own international stocks, others may prefer to own an international equity fund.

The Bottom Line

Modern portfolio theory has been built on the assumption that you can't beat the stock market. If you can't beat the market portfolio, then the best you can do is to match the market's performance. Therefore, academic theory revolves around how to build the most efficient portfolio to match the market.

We have taken a different approach. Our objective is to outperform the market. Therefore, we believe that our odds increase by holding (not actively trading) relatively concentrated portfolios of between 12 and 20 great companies purchased with a margin of safety. The circle of competence will be unique to every person; therefore, your stock portfolio will naturally have sector, style, and country biases. If lacking in any area such as international stocks, a good mutual fund can be used to balance your overall portfolio.