How to buy shares with big potential while still protecting yourself against heavy hits.
Twenty years ago the cutting edge of grocery was the bin shop, where cocoa, cornflakes and custard powder were arrayed in laundry basket size tubs. I loved shovelling soup powder and soap powder into plastic bags (separate ones), imagining how much money I was saving with every scoop.
In one shop the owner proudly told me that his special soup mix was made from seven different soup powders. Perhaps Goldilocks would have preferred this most average of soups - I didn't. However, in investing, a well chosen mix will give your portfolio a flavour that's less volatile and easier on the stomach. The problem is how much of each share to put in?
In My Biggest Holding David Kuo discussed the merits of buying big in the companies you have the most confidence in. There's a lot to be said for this provided you can remember you are not infallible. Another approach is to weigh your holdings according to risk.
The risk weighted portfolio
Here's how make a Goldilocks Portfolio, where the weighting of each position just right. Most of us think of risk as how much money could you lose on a share. Here are some examples of companies that have stumbled:
Company | Problem | Type of share | Price fall | Period |
|---|
Marks & Spencer
(LSE: MKS)
| Complacent management,
dull ranges, sharper
competitors. | Safe FTSE100,
property backing,
strong brand | 50% | 1998-2000 |
Sainsbury
(LSE: SBRY)
| Even more complacement
management,
competitors especially
Tesco raise their games. | Safe FTSE100,
property backing,
strong brand | 55% | 1998-2000 |
Regal Petroleum
(LSE: RPT)
| Poor drilling news from
hyped oil field. | Oil exploration,
speculative | 85% | 2005 |
ARM
(LSE: ARM)
| Growth falls from 50%pa
to negative, crazy TMT
share valuations return
to normal. | High quality
tech growth | >90% | 2000-2002 |
| Homebuy | Overexpansion, manage-
ment mistakes, high debt | Low quality
growth | 100% | 2006 |
| Mayflower | Falling sales in tough
market, high debt | Recovery | 100% | 2002-2004 |
This is where you have to swap your rose tinted glasses for a pair of flinty faced accountant's black horn rims. Companies can do worse than you think possible, especially if you've bathing in the warm and comforting shallows of the front half of an annual report.
To cook up a risk weighted Goldilocks portfolio first take a stab at the bad-case price fall (call this F%) for every share and ask yourself "How much am I prepared to lose?" (and this L). The maximum value of your holding in that company is then L / F. For a share where F = 85% and a maximum loss of £500 your maximum holding would be £588.
If you aren't limited by your maximum losses then a weighting of 1/F in each share would be just right. For the above examples (if you had correctly guessed the bad-case fall) you would hold £200 of M&S for every £100 of Mayflower.
It's very rare for a safe large cap to lose 50%, so I'd use a figure of 30% myself. A Goldilocks portfolio might then look like this:
| Company | Bad-case fall | Amount invested |
|---|
A | 30% | £333 |
B | 30% | £333 |
C | 50% | £200 |
D | 90% | £111 |
E | 100% | £100 |
A weakness of risk weighting is that there's only a factor of three between a blue chip and Thieving Liars Mining Plc. Also if you like to hold a few recovery or speculative situations you end up with roughly the same amount of money in each.
There's two more ways to balance your holdings but that would make this piece too big instead of just right, so they appear in the second part of this article.
Alun has a short (down) spreadbet on Sainsbury.
