Published On: May 21, 2019

Written by: Ben Atwater and Matt Malick

As client needs have evolved over the years, we’ve focused more of our client notes on the ultimate goals of investing, specifically retirement, and less time discussing the minutia of our investment portfolios.  But that doesn’t mean our investment approach is any less important in helping our clients meet their goals.  In fact, a disciplined, transparent investment process that minimizes costs and reduces the likelihood of mistakes is critical.

We have always believed in building portfolios primarily with individual securities rather than opaque investment products.  Our typical client account consists of positions in our core basket of individual stocks, combined with a series of “laddered” individual bonds.  The exact mix between the two depends on each client’s goals, time horizon and risk tolerance.

Most financial advisors, on the other hand, “outsource” portfolio management by purchasing numerous mutual funds and exchange-traded funds (ETFs).  But by using individual securities, our clients largely avoid product-based expenses, resulting in better net-of-fee returns.  Even small savings, compounded over many years, can result in a much larger investment portfolio, all things being equal.

The greater transparency afforded by individual securities also helps both us and our clients to maintain an allocation to equities during periods of market volatility.  It’s easier to stay the course during market routs when you know what you own and why you own it.  The stock market has been wobbling again lately, based on an escalating U.S.-China trade war and saber-rattling between the U.S. and Iran.  If markets fall into a full-blown correction or worse, it’s easier to justify a long-term position in a company you know and understand than in an opaque investment product.

Central to our investment approach is the belief that adequate portfolio diversification can be achieved with a limited number of stock holdings.  Whereas the average portfolio of mutual funds and / or ETFs represents hundreds or even thousands of underlying securities, our typical client portfolio contains fewer than 25 individual stocks.

Aside from anecdotal evidence from managing portfolios during our careers, several statistical studies have supported the diversification benefits that can be achieved from a “concentrated” portfolio of 20-30 stocks.

The chart below offers additional confirmation, tracking the historical correlation between the Dow Jones Industrial Average and the Standard & Poor’s 500.  Perfect correlation, meaning the indices move in unison, would be 1.0, whereas a correlation of -1.0 would imply that the indices move inversely with one another.

Over the last 50 years, the correlation has never fallen below 0.7 and has typically been north of 0.9.  Such high correlation is fascinating and constructive for investors in a “concentrated” portfolio.  The Dow Jones Industrial Average, a basket of 30 stocks, has largely tracked the S&P 500, an index of 500 stocks.

It’s important to note that the two indices are calculated differently.  The Dow is weighted by share price whereas the S&P 500 is weighted by market capitalization, or share price multiplied by shares outstanding.  The largest Dow component is its highest-priced name (currently Boeing, which has a share price of $355 and a market capitalization of about $200 billion) and the largest S&P 500 holding is the biggest company by market capitalization (currently Microsoft, which has a share price of $128 and a market cap of about $980 billion).  Both stocks are in both indexes, but Microsoft’s weight in the Dow is about a third of Boeings, while Microsoft’s weight in the S&P 500 is nearly five times that of Boeing. 

This methodology difference doesn’t detract from the main message that investors can achieve portfolio diversification with a limited number of holdings.  And in our experience, a limited number of individual securities offers several advantages for long-term investors, namely lower costs, greater transparency, the potential to harvest capital losses, and a better ability to ride out periods of market turmoil.

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