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501-Constructing a Portfolio   
  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 Genius explains 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.