Tony Morgan leads you through the process of how to think about portfolio diversification in a practical way, with examples

How you build your investment portfolio from scratch, staying sensible, but achieving the wonders of actual wealth creation, is entirely up to you.

My writings are here to help guide where applicable, to help develop your repertoire of concepts useful in investment decision making.

Today I am saying that any one individual should initially target up to seven stocks in their portfolio. This number can be adequate for diversification purposes if the correlation between each stock is relatively low. What do I mean by correlation?

Let’s quickly jot down an example, in this case using NZX 50 stocks as a reference.

Now this is just an idea snapshot, there are many more sectors, and another 44 more stocks to allocate to any one sector. I am staying really simple here. And it is only a primer example for illustrative purposes; it is not a recommendation.

The important point which needs to be ultimately gleaned through actually investing over time, is that those companies if compared to each other will both perform sufficiently differently to give an investor adequate diversification. This will push portfolio return volatility lower, smoothing the long term returns, whatever that may be.

At the heart of this explanation, is that, as most of you will realise, each business sector acts most of the time independently from each other.

For example, Contact Energy (CEN) and Spark (SPK) have sticky customer bases that pay them monthly, a recurring revenue stream. Quite nice, a less volatile business model than say The Warehouse.

The Warehouse (WHS) relies on discretionary consumer spending, potentially a more volatile business model that is subject to pricing, promotions and what products are in vogue. Inventory costs are of upmost importance.

Mainfreight (MFT) is dependent on consumer demand as well, this time though being general trade. It might get some business in fact from what The Warehouse is doing, given it is likely The Warehouse, or their customers are clients. However, Mainfreight is now a global logistics powerhouse diversified across not just country borders, but type of client. 

Even we were clients earlier this year as we carted our beloved native and exotic plants from the south to our north abode!

Clearly Air NZs (AIR) business has been massively disrupted from Covid19. So, if you have had this in your portfolio over the last few years, then obviously, it has been a disappointing investment. But hey, in this example it has only been one of six investments, so you are not entirely disappointed overall.

For instance, Fisher and Paykel Healthcare (FPH) has had a massive benefit as Covid 19 has raged the world. Their humidifier products have been in hot demand. Furthermore, this company is not just a simple manufacturer of health products. The technology involved in producing them is extensive, thus the substantial amounts of research and development spend. This company is very much technology driven. New ways to make even better products for clients.

You see also that FPH spans multiple sectors! Our NZX top 50 doesn’t really have a great range of companies that adequately span all investment sectors. So here I have filled the gap. But you as an investor can go beyond.

The Global Opportunity

Over the last 25 years there has been a massive increase in the opportunity to invest globally. Thus, the opportunity to diversify away from just NZ companies has naturally followed.

I am not saying you have to follow that trend, but clearly there have been benefits.

FPH is our biggest listed company, however if you open your eyes to the rest of the world globally there are thousands of companies the size of FPH or much bigger and with business models that span multiple investment sectors that are not available in little New Zealand.

But don’t forget, where you invest is up to you. Follow your hunch, you interest, your intuition, where your research progress’s.

And going back to the number seven.

The scope of your understanding will be constrained and limited; thus, I am suggesting seven investments, if adequately diversified, will be on the edge of what you can properly contend with, keep in the know with what is most important with each investment. This focus will ultimately be rewarding wealth wise, without bruises too big to cause long term trouble.

For instance, in my very brief example above the most painful investment has been Air New Zealand, but the rest of the portfolio has helped you through. (yes I know no statistics on total returns etc., but please accept my generalisation).

There are more interesting features within the above combination of investments.

 All, with the exception of Air NZ pay a dividend, mostly growing dividends as all those five companies are generally growing operations within their field of expertise.

Also, you pick up the benefits of global trade by investing in FPH and MFT.

That none of the Amigos own any of the above stocks (might be in my Kiwisaver Portfolio, but I have no idea!) emphasises again that we can be authentic since there are so many investments to choose from. You can see how portfolios and their construction can be different.

Some of you will say, hey Tony, how come you don’t own great performers like FPH and MFT. Firstly, I say again, you cannot be in everything and secondly, sometimes decision-making will be such, that you do miss out on the great ones (we will follow up on this topic another time as is interesting for developing your investment awareness, reducing that gloom topic of regret, and improving your investment skill for the next opportunity).

Yes, I missed on FPH around 2012. FPH was a tad over $2 and I hesitated, didn’t quite understand the long-term story to push the button and buy…never mind, I am over it.

And even though I had a part-time job as a sorting freight many years ago, I never got the story on MFT till recently. Dumb. My Mum owns MFT, she’s really happy and reminds me!

An Amigo and his trail of investments

The Shepherd over the last 18 months has generally been following the logic above as I have portrayed.  However, as you will see below, perfect execution is rarely achieved, the process being a journey we can learn upon.

He only began investing last April at the age of 34.

From scratch, but with a gun of cash loading constantly (through inheritance and monthly savings) his total investments now are valued approximately $250,000. Like all new ventures, this curve of learning to invest (not just theory) has been pronounced.

In 18 months, he has traded, bought and sold about 10 stocks. This has been a function of both positive short term trades, where he wasn’t prepared to ultimately be a long-term investor (against his initial investment goals). He has taken losses where he thought the situation was going to potentially even get worse, and thirdly were he just got bored with the particular investment compared to his intuitive initial expectational thinking.

And now he has about twelve stocks and a few small ETF holdings. About 45% of his portfolio is in technology, mostly skewed to the semiconductor sector. He has a bias to small capitalisation stocks.

So, you can see how active the Shepherd has been. Very. Too much one would suggest.

From my perspective, knowing the Shepherd reasonably well, is that his enthusiasm together with the substantial monies he been presented with, has naturally caused all this action.

He will wise up over time I suspect. I am saying this, because as many of you will know, you do not need to be so active. His youthfulness, eagerness to invest those funds has fueled the fire, probably like many readers. Nothing wrong with that, but the secrets of successful investment really do lie in a longer term, more controlled investment mandate (unless you are a sophisticated trader, another story). 

The crux is that business’s may present quarterly reports, have share prices that fluctuate dramatically (we do want to be aware of this variable though), but the proof in all business ventures and their truer worth (in most instances) lies in taking a more longer term approach. I know, at the best of times we can only see the vision (the business dynamic) no more than say two, at most three years ahead, whereas most businesses will be planning way beyond that time frame and so the big rewards from companies executing over longer terms will naturally accrue to those investors who can hang on as long as possible (heck, not easy).

Ideally our mindfulness, our business awareness needs to be broadened to the point where we don’t just jump from hither to tither.  With liquid investments like stocks the latter is easy to do, say relative to real estate (I have my doubts here in New Zealand as the media frenzy keeps this subject firmly in our minds? Actually, you don’t hear much about commercial real estate? (surely a bastion of long term wealth accumulation rather than just residential?)). One must force oneself to think beyond the present, beyond the short-term trivia of conflicting uncertainty (further discussion here obviously, another day).

So, gather your thoughts on applying diversification in building your own investment portfolio.

Accumulating stocks in a timely, consistent manner is what we want to touch on next. This is where the pipeline of ideas comes in handy. I will be back to discuss this topic.

Next week however, we talk about the real deal.

Tony Morgan has run a portfolio management business and an equity brokerage, both of which were purchased by Craig Investment Partners. He now runs a small family office that invests globally. Other articles in this series can be found here. And the profiles of all the NZX50 companies can be found here.