Construct a Stock Portfolio Like an Investing Pro

I spend a good deal of time on two of our more widely read newsletters – High Yield Wealth and Personal Wealth Advisor. “How do I construct a stock portfolio using your recommendations?” is a recurring question I receive from readers of both publications.stones zen garden

Starting can be the most daunting aspect of any endeavor, including investing. At any point in time, a High Yield Wealth reader will confront a list of 30-to-35 recommendations. Because we offer three distinct lists of recommendations, a Personal Wealth Advisor reader will confront a list of up to 45 recommendations. And if someone subscribes to both publications, well, you can do the math.

Many readers wonder if they need to buy every recommendation, and many are overwhelmed by the prospect of doing so. They are taught that they need 40, 50, or even a hundred securities to properly diversify market risk.

Of course, we wouldn’t recommend an investment if we didn’t think it could generate positive returns. That said, we choose our recommendations not only for individual merit, but for their fit within a portfolio context.

You could buy every one of our recommendations, but you don’t have to. You can create a balanced, diversified stock portfolio with as few as 20, or even 15, of our recommendations. Many investing greats understand that the greatest investing fortunes are frequently created not through broad diversification, but through intelligent concentration.

Consider Berkshire Hathaway (NYSE: BRK.b). It’s a massive conglomerate today, but it wasn’t always that way. Robert Hagstrom, in his book The Warren Buffett Way, reveals how Berkshire’s investment portfolio was structured during Berkshire’s heyday in the 1970s and 1980s. It was very concentrated.

From 1977 through 1983, Buffett rarely pushed Berkshire’s investment portfolio beyond 10 issues. During that time, Berkshire’s own share price galloped along at a 50% annual rate.

But was Berkshire Hathaway a riskier investment then?

Contrary to popular conception, superior returns through portfolio concentration doesn’t mean accepting outsized risk. Academic research backs my contention that higher-return diversified investment portfolios can be constructed with fewer issues without accepting additional risk.

An influential 1968 article written for the Journal of Finance  ̶  “Diversification and the Reduction of Dispersion: An Empirical Analysis”  ̶  showed that as few as 10 securities can reduce volatility to a level virtually identical to that of the market. The authors found that gains to diversification are obvious and particularly strong up to five stocks. When a portfolio reaches 15 stocks, the maximum benefits are achieved. After that, the curve levels out and risk-reduction gains from adding additional securities are minimal.

The problem for individual investors is how to actually construct a concentrated stock portfolio. Fifteen gold-mining penny stocks will hardly do the trick. For that matter, 15 of the world’s largest energy stocks won’t either.

Balance is key. You don’t want to overweigh an individual security or an individual sector in your portfolio.

You might like Apple (NASDAQ: AAPL) as much as anyone likes Apple, but you don’t want Apple to be your sole investment. What’s more, you don’t want a portfolio of one-sector Apple-esque stocks. You like Apple, and you like the tech sector. A portfolio of Apple, Microsoft (NASDAQ: MSFT), Cisco System (NASDAQ: CSCO), etc. would produce an improperly diversified portfolio.

Economist John Maynard Keynes provided insight on portfolio diversification long before the academicians: Keynes noted that an investor wants a balanced investment position – with a variety of risks in spite of holding fewer stocks. You want to match uncorrelated businesses. You like Apple, but you might consider matching it with another unrelated stock.

For example, you like Apple, but you also like United Natural Foods (NASDAQ: UNFI), a large distributor of organic foods and health products. The two companies are unrelated. If you construct an investment portfolio composed of 10 such unrelated pairings (20 stocks), you’ll be well on your way to creating an efficient, diversified stock portfolio.

The good news is that you can derive many such combinations of investments from our High Yield Wealth and Personal Wealth Advisor recommendations. We supply the recommendations; you combine them as you see fit.

Published by Wyatt Investment Research at