Thoughts on Portfolio Management

How many stocks?...And at what allocations??...How the heck am I supposed to figure all this out?!?

In last month’s post on stock selection, I referenced the email that planted the seed. It also asked for opinions on portfolio management, but I found it too complicated to address both at once. Today I’ll try to fill the rest of the request. As with stock picking, I believe managing a portfolio is a personal matter with parameters that change over time. That means there is no definitive approach, so I will not try to give one. All I can do is describe my process and encourage anyone reading to take or leave whatever they choose.

In broad terms I consider portfolio management a little art and a little science. Nothing earth-shattering there as I think most would generally agree with that statement. The key is finding the balance that works for you. In my case I seek a framework that makes logical sense but also has the freedom and flexibility to move around within it. That does not mean a set of rules I can ignore whenever convenient. Instead, I want thoughtful guidelines that evolve as conditions dictate. Ideally, I design a system in which my perspective continually alternates between this:

and this:

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Still, managing a portfolio is not just changing focus between big picture and small. It is also squaring logic and reason with emotion and intuition. The almost infinite combinations of these factors is why finding a one-size-fits-all portfolio system is for all intents and purposes an impossible task.

As I set out to describe my method, I hope it doesn’t sound too formulaic. It is not meant to be. To be clear, I do not in any way believe you can simply math your way to maximum returns. At the same time, we all need a baseline for making buy/sell/hold decisions. Over time I have found my best decisions come after letting the numbers start my internal monologue. Breaking it down, my portfolio conversations have evolved into something like this:

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First and foremost, I wholeheartedly believe conviction is the most important element of building and maintaining a quality portfolio. It not only dictates buys and sells but often determines your ability to hang tight when things are not going your way (anyone remember March, 2020?). Conviction is what lets you recognize and navigate volatility rather than doubting yourself every time a stock swings up or down. It also helps you stay focused on bigger goals rather than constantly getting stuck in the weeds.

The numbers are the underlying truth of company execution. Whether in an earnings report or company filing, the numbers themselves are never biased. The challenge is interpreting them properly. Personally, I seek companies with growth, margins, cash flow, and profitability trends implying a dominant future. I realize there are many ways to parse that statement, but I’ll keep it simple to start. At its core I want numbers suggesting a long-term winner. Some thoughts on reviewing those numbers can be found here, here and here.

When assessing narrative, I want the company’s story and message to mirror the relative strength of the numbers. Reviewing conference calls and management comments can give valuable insight into a company’s future. Words and tone matter, so pay close attention to both. While management is always in sales mode, executives are well aware straying too far from the truth could put them in a dangerous spot. The clues are all there. Our job is to sort through them and line them up as needed.

Once I have my conviction, I am ready to gauge just how much of the company I am willing to own. I do not have set allocation ranges per se, but for the purposes of this article I would group them something like the tiers below. When reading through them, please focus on the words rather than the percentages. The verbal descriptions are definitely the more important point.

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Tier 1: 3%-5%

The range in which most stocks enter my portfolio. Being honest, I let the numbers carry much more weight than narrative to start even though I will have done due diligence on both. While I want to understand the basic story, performance must carry the day. If I can not piece the numbers together in a way that suggests a dominant company, the stock is a pass regardless of how sexy the story might sound.

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Tier 2: 5%-8%

This is where the narrative starts to kick in. I tend to bump stocks into this range after learning more of the story and liking what I hear.

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Tier 3: 8%-12%

By this point the company is carving out a well-rounded niche. I understand its past performance and more importantly management’s plans for the future. In some ways this is the sweet spot where the numbers and narrative start to feed off each other.

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Tier 4: 12%-15%

At this stage the company starts flexing its muscle and has earned enough street cred for a more aggressive allocation. In this tier I consider the potential reward far enough ahead of the risk to merit a double-digit allocation.

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Tier 5: 15%+

My portfolio flagships. These are my best ideas and strongest convictions, so I want to push the allocation envelope. In almost all cases I have owned or studied the company for several quarters at least. Most increases above 15% happen through price appreciation rather than additional purchases. If I have chosen correctly, the company should take care of itself once it enters this tier.

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Now that I have my tiers, how do I decide which stock goes where? Well, I guess this is where the art comes in. First and foremost, I make my biggest positions those in which I have the most conviction. Think about it for a second. Why wouldn’t we give our top ideas the most money? That logically seems our best chance to beat the market, yet it is amazing how many signals we receive to do just the opposite. We are constantly reminded to rebalance, average down, build out lesser holdings, and further diversify into more and more names. The problem is beyond a certain point I have yet to see convincing evidence these strategies actually increase returns (which I thought was the whole point). While I understand the concept of spreading risk, shouldn’t I also avoid potentially limiting returns? Again, balance is key. It is quite the conundrum.

I have come to look at it this way: what coach has ever given more playing time to less talented players and consistently won more games?*** None that I know of. And make no mistake, you are the head coach of your portfolio. You decide how many firms get to play and how much money each receives. You should always keep that responsibility in mind. I know I try to.

[***If you prefer a business analogy, what boss has ever given more responsibility to less talented employees and consistently seen better results? Again, you are the boss of your portfolio. You can fill in the rest from there.]

At this point I feel it is important to remind everyone the percentages above apply only to me and no one else. I have been asked many times how I can stomach 15%, 20%, or even 25% of my portfolio in just one stock. (And before you ask: yes, our portfolio is the overwhelming majority of our net worth.) The only answer I can give is because it is my stomach, and it hasn’t always been this way. Everyone has a maximum allocation that still lets them sleep at night. Mine just happens to be higher than most. I have also spent years learning what I like, what I don’t and how big an allocation I am willing to hold. Not to mention the fact my experiences and temperament are unique to me alone. Just because I was asked to share some thoughts on the internet does not mean my methods are right for anyone else. As I have said ad nauseam, everyone must find their own way.

So, why bother to write all this down? Well, while I wouldn’t rigidly endorse any one set of percentages, I do believe thinking in terms of convictions can be useful to just about anyone. It only needs to be tweaked for goals, temperament and timeline. If you are someone who prefers narrative over numbers, I happily say you do you! Can you have 3 conviction tiers? Or 7? Or 10? Absolutely. Who says you can’t? You might choose a 0.5% entry allocation with a maximum of 2% …or 5% …or 50%. You can set a portfolio limit of two stocks or 102. Again, any of those is perfectly okay. The point is everyone has an ideal mix. You just need to search yours out and then be willing to refine it as you go. Only your mix matters and no one else’s!

We fallible human beings have a habit of making things more complicated than they need to be. In this case, the challenges of portfolio management are magnified by the woeful lack of financial education in much of the world. As a result, many investors tie themselves up in knots trying to sort it all out. Don’t. Keep it simple instead:

1. Do I like this company?

2. Am I comfortable with how much I own?

If the answer is yes to both, you are almost certainly on the right track. All you need to do is build from there. Take your time, think things through, trust yourself, and act appropriately. My experience says those who can do all that seem to end up just fine.

Thanks for reading and good luck out there. As usual, the comments are open.