The Case for a Few Good Stock Runners

The Case for a Few Good (Stock) Runners

Many investors limit the amount of their investments in individual companies to manage the risk in their portfolios.  Others advocate holding on to stocks whose prices increase faster than the rest of your portfolio (which I’ll call stock runners) as long as the reason you bought the stock in the first place continues to hold true.  I’ve taken the latter approach with my portfolio with some success.

In this post, I’ll talk about how many stocks you might want to hold in your portfolio to maintain diversification.  I’ll then explain both strategies for dealing with stock runners in more detail.  I’ll close with an explanation of how the strategy of holding on to stock runners worked for me and provide examples of when it wouldn’t have worked.

How Many Stocks to Hold

If you plan to invest only in individual stocks (as opposed to including mutual or exchange-traded funds in your portfolio), many advisors recommend that you make investments in at least 10 companies.  Ten provides a balance between the amount of time needed to research a possibly longer list of companies to make an informed decision and creating diversification.

A Poor Performer

The goal of diversification is to reduce the impact of the poor performance of one stock on your total portfolio returns.  In my post on diversification and investing, I used PG&E as an illustration.  The chart below shows PG&E’s daily stock price over the 12 months prior to PG&E declaring bankruptcy in early 2019.

In the twelve months ending January 26, 2019, PG&E’s stock price dropped by 72%.  From its peak in early November 2018 to its low in January 2019, it dropped by 87%.

 The Benefit of More Stocks

Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you invest in companies in different industries.   If the only company in which you owned stock was PG&E, you would have lost 72% of your investments in one year.  If, on the other hand, you had owned an equal amount of a second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%.  The graph below shows how much you would have lost for different numbers of other companies in your portfolio.

Portfolio returns by number of stocks

This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio.  In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss.  With 10 stocks (circled in red), the loss is reduced to 12.6% which isn’t much worse than the 6% loss for the Dow Jones Industrial Average.

The curve starts to flatten out quickly at about 10 stocks, supporting the common rule of thumb that a portfolio of only individual stocks should have representation from at least 10 companies.

Options when You Own Stock Runners

There are two schools of thought about how to treat stock runners.

  • One is that you should sell a portion of your holdings so that the value of your holdings in any one company is no more than 10% (one-tenth) of your total portfolio.
  • The other is that you should let your winners run. The latter view is consistent with the advice of Peter Lynch, one of the most successful mutual fund managers ever, who advocates looking to buy stocks that could become ten-baggers (worth 10 times what you paid for them).

When Holding on to Stock Runners Works

I have taken the latter approach and will use two of the stocks that have been in my portfolio for close to 30 years to illustrate.  Let’s say I had $100,000 to invest in 1992.  I put 10% of it in each of Boeing (BA) and Neogen (NEOG) stock.  I put the rest in an S&P 500 index fund.  (That’s not really what I did or the amount of money I had, but the changes make the example simpler.)

Neogen performed very well between May 1992 and August 1, 2020.  $1 invested in Neogen on May 1, 1992 was worth $169 on August 1, 2020!   By comparison, $1 invested in 1992 in the S&P 500 was worth $8 in 2020 and $1 invested in Boeing stock in 1992 was worth $16 in 2020.

The Two Strategies

The chart below shows what would have happened if I had managed this portfolio since May 2, 1992 under the two different strategies.  The purple line shows the strategy I use – buy and hold or let stock runners run.  The green line shows what would have happened to the value of the portfolio if I had trimmed my positions in Neogen and Boeing once a year so that the mix was 10% in each of Neogen and Boeing and 80% in the S&P 500.

Net Worth comparison including Boeing and Neogen as stock runners

The Benefit of Keeping Stock Runners

From 1992 until mid-2008, there really wasn’t much difference in the results of the two portfolios.  Since then, both Boeing and Neogen have significantly outperformed the S&P 500.  The purple line therefore moved above the green line and has consistently stayed higher.  On August 1, 2020, the purple line shows that the buy-and-hold portfolio had a value of $2.5 million.  The trimmed portfolio (green line) had a value of just over $1.5 million on the same date or only 60% as much.

Boeing had particularly poor results in the 10 months starting in October 2019.  Its price on August 1, 2020 was only slightly more than half of what it was on October 1, 2019.  Similarly, Neogen hit a high of 200 times its May 1, 1992 price in April 2018.  You can see these peaks in the purple line in the chart.  Even with these significant declines in Boeing’s and Neogen’s prices recently, the buy-and-hold strategy produced 66% higher returns.  If I had been able to anticipate these decreases and thinned my positions in these two companies in 2018 or 2019, my net worth on August 1, 2020 would have been even higher.

I caution that this example is somewhat extreme.  There are very few stocks, such as Neogen, that have produced such consistently high returns.  Nonetheless, the illustration highlights the benefits and risks of letting your stock runners run.

When Trimming Your Positions is Better

Before you get too excited about the buy-and-hold strategy, you should know that you can’t use it blindly.  I’ll use the examples of General Electric (GE) and Pacific Gas & Electric (PG&E).  I owned GE for a while and have a family member who owned PG&E, so am familiar with both companies.  From May 1, 1992 through early 2017, GE significantly outperformed the S&P 500 (increasing in price by a factor of 30 vs. 5.5) and PG&E produced roughly market returns, but was considered a reliable stock with a generous dividend.  Starting in 2017, both companies encountered financial difficulties and lost substantial portions of their market value.

The chart below shows the same comparison as above – buy-and-hold vs. trimming your positions – using GE and PG&E in place of Neogen and Boeing.

Net Worth comparison including GE and PG&E as stock runners

While the companies were doing well (up to the 2008 financial crisis), the buy-and-hold strategy produced better returns.   For the next 8 or 10 years, the two portfolios performed similarly.  Once the two companies encountered difficulties, though, in 2017, the annual trimming strategy started to outperform.

Conclusion

The conclusion that I draw from these illustrations is that, as long as you think a company can outperform the market, you will likely be better off letting your stock runners run.  However, if something changes at the company, you will likely be better off trimming the larger positions in your portfolio, at a minimum, or selling all of your stock in the company.  This conclusion reinforces the points Peter Lynch made in his book, One Up on Wall Street, that you should know the story behind every stock you own.  Brandon Smith makes a similar recommendation in his guest post for me that changes in a company’s management, market or financial position can be important sell signals.

 

Why I Chose Patience over Re-balancing

Investment-Rebalancing

Many financial advisors recommend re-balancing your portfolio no less often than annually to ensure the asset allocation is consistent with your risk tolerance, as illustrated in this post from Schwab.  In the past, I haven’t been one to re-balance my portfolio, so I spent some time thinking about why I haven’t followed this common advice.  Up until recently, almost all of my invested assets have been equities, equity-based mutual funds or exchange-traded funds (ETFs).  As such, I didn’t need to do any re-balancing across asset classes.

In this post, I’ll explain re-balancing, its specific purpose and examples of its benefits and drawbacks.  I’ll also explain my strategy (which may or may not be right for you).

What is Re-balancing?

Re-balancing is the process of buying and selling securities in your portfolio to meet certain targets.  In the case of asset classes, the primary purpose of re-balancing is to maintain your target risk/reward balance.

Some people have targets that define their desired allocation across asset classes.  One common rule of thumb is that the portion of your portfolio that should be in bonds is equal to your age with the rest in stocks.  In my case, that would mean roughly 60% of my portfolio in bonds and 40% in stocks.  The goal of this rule of thumb is to decrease the volatility of your investment returns as you get older and closer to that age at which you need to draw down your assets in retirement.

How Does Re-balancing Work?

The process of re-balancing is fairly simple.  Periodically, such as once or twice a year, you compare the market value of your investments with your targets.  If there is a significant difference between how much you own in an asset class and your target percentage, you sell the portion of your investments that is above the target and reinvest the proceeds in something different.

Let’s say your target is 75% stocks and 25% bonds.  You start the year with $10,000 of investments – $7,500 in stocks and $2,500 in bonds.  If stocks go up by 10% and bonds go up by 5%, your year-end balances will be $8,250 in stocks and $2,625 in bonds, for a total of $10,875.  Your targets though are $8,156 of stocks (75% of $10,875) and $2,719 of bonds.  To put your portfolio back in balance, you would need to sell $94 (= $8,250 – $8,156) of stocks and buy $94 of bonds.

You can avoid selling any assets if you have money to add to your investments at the end of the year.  Continuing the example, let’s say you have another $500 available to invest at the end of the year.  That brings your total available for investment to $11,375 (= $10,875 of investments plus $500 cash).  Your targets would be $8,531 (= 75% of $10,875) for stocks and $2,843 for bonds.  In this case, you would buy $281 of stocks and $219 of bonds to meet your targets, eliminating the need to sell any of your assets.

What Does Asset Allocation Do?

The chart below compares the average annual returns and risk profiles of several sample portfolios with different mixes between stocks and bonds.  In the middle four portfolios, the first number is the percentage of the portfolio invested in stocks and the second number is the percentage in bonds.

Annual Returns for Different Asset Allocations 1980-2019

Average Returns

In this chart, the average annual return is represented by the blue dash.  When the blue dash is higher on the chart, it means that the returns on the portfolio were higher, on average, over the historical time period.

Volatility

The green boxes correspond to the ranges between the 25th percentile and the 75th percentile.  The whiskers (lines sticking out of the boxes) correspond to the ranges from the 5th percentile to the 95th percentile.   When the box is tall and/or the whiskers are long, there is a lot of volatility.  In this case, it means that the annual return on the portfolio varied a lot from one year to the next.  At the opposite end of the spectrum, when the box and whiskers are all short, the range of returns observed historically was more consistent.

Comparison of Portfolios

I have arranged the portfolios so that the one with the most volatility – 100% in the S&P 500 – is on the left and the one with the least volatility – 100% in bonds as measured by the Fidelity Investment Grade Bond Fund (FBNDX) – is on the right.  You can see how adding bonds to the S&P 500 reduces volatility as the height of the boxes and whiskers gets smaller as you move from left to right.  At the same time, the average annual returns decrease as bonds are added to the portfolio.  Over the time period studied (1980 to 2019), the S&P 500 had an average annual return of 8.7% while the Bond Fund had an average annual return of 7.2%.  By comparison, returns on investment grade bonds are currently generally less than 4%.

Another Perspective

Because stocks and bonds are not 100% correlated, the volatility (spread between tops and bottoms of boxes and whiskers) of owning a combination of both is less than the volatility of owning just the riskier asset – stocks.  As I was preparing the chart above, I noticed, though, that the bottom whisker for the 100% bonds portfolio goes lower than the bottom whisker for the 80% bonds portfolio.

Specifically, there were more negative returns in the historical data (i.e., more years in which you would have lost money in a single year) if you owned just bonds than if you owned the portfolio with 80% bonds and 20% stocks.   The 80% bond portfolio had a negative return only 7.5% of the time while the 100% bonds portfolio had a negative return 10% of the time!  As more bonds are added to each portfolio, the blue bar/average moves down.  This downward shift actually moves the whole box and the whiskers down.

This relationship can be seen in the chart below.

The dots correspond to the portfolios in the previous chart with labels indicating the percentages of stocks in the portfolios.  The horizontal or x-axis on this chart represents the average annual return.  Values to the right correspond to higher average annual returns (which is good).  The vertical or y-axis represents the percentage of years with a negative return.  Values that are higher on the chart correspond to portfolios with more years with negative returns (which is bad).

Optimal Portfolios

“Optimal” portfolios are those that are to the right (higher return) and/or lower (fewer years with negative returns).  Any time a point is further to the right and at the same level or lower than another one, that portfolio better meets your objectives if probability of having a negative return is your risk metric.

More Stocks Can Be Less Risky

I have circled two pairs of dots.  The ones in the lower left corner are the two I’ve mentioned above.  The 20% stocks (80% bonds) point is lower than and to the right of the 0% stocks (100% bonds) point.  As you’ll recall, the average return on the 20% stocks portfolio is higher than the average return on the all-bond portfolio so the dot is to the right (better).  The percentage of the time that the annual return was less than zero was smaller for the 20% stocks portfolio so the dot is lower (also better).

There is a somewhat similar relationship between the 60% and 80% stocks portfolios (circled in green in the upper right).  The 80% stocks point is at the same level and to the right of the 60% stocks point.  As such, if average annual return and probability of a negative return are important metrics to you, moving from 80% to 60% stocks or 20% to 0% stocks would put you in a worse position as you would have less return for the same risk.

Re-balancing Can’t Be Done Blindly

Setting a target asset allocation, such as 80% stocks and 20% bonds, allows you to target a risk/reward mix that meets with your financial goals.  As I indicated, the purpose of re-balancing is to ensure that your portfolio is consistent with your goals.  However, it is important that you considering the then-current economic environment when re-balancing.

Interest Rates

For example, interest rates are lower than they were at any point in the historical period used in the analysis above.   Over the next several years, interest rates are unlikely to decrease much further, but could stay flat or increase.  If interest rates stay flat, the returns on bond funds will tend to approach the average coupon rate of bonds which is in the 1% to 3% range depending on the quality and time to maturity of the bonds held.  This range is much lower than the average annual return of 7.2% in the illustrations above.

If interest rates go up, the market price of bonds will go down, lowering returns even further.  As such, the risk-reward characteristics of bonds change over time.  I would characterize them as having lower returns and higher risk (the one-sided risk that prices will go down as interest rates go up) now than over the past 40 years.

Stock Prices

Similarly, the S&P 500 is currently close to or at its highest level ever in a period of significant economic and political uncertainty.  While I don’t have a strong opinion on the likely average annual returns on the S&P 500 in the next few years, I think it is likely to be more volatile in both directions than it has in the recent past.

If you re-balance your portfolio, you will want to form your own opinions about the average returns and volatility of the asset classes in which you invest.  With these opinions, you can decide whether the asset allocation you’ve held historically will still provide you with the risk/reward profile you are seeking.

Re-balancing and Income Taxes

Another consideration when you are deciding whether and how often to re-balance your portfolio is income taxes.  Every time you sell a security in a taxable account, you pay income taxes on any capital gains.  If you lose money on a security, the loss can offset other capital gains.  On the other hand, if you own the securities in a tax-free (Roth or TFSA) or tax-deferred (traditional or RRSP) account, re-balancing has no impact on your taxes.

Re-balancing Example

Let’s look at an example of the taxable account situation.  If you targeted a portfolio of 60% stocks (in an S&P 500 index fund) and 40% bonds (in FBNDX) from 1980 through 2019, you would have made the transactions shown in the chart below.

Rebalancing Stock Transactions

In this chart, the bars represent the amount of the transaction as a percentage of the amount of stocks held at the beginning of the year.  A bar that goes above zero indicates that you would have bought stocks in that year.  A bar that goes below zero indicates that you would have sold stocks in the year.  The proceeds from every sale would have been used to purchase the bond fund.  Similarly, the money used to purchase stocks would come from a corresponding sale of the bond fund.

In every year, you either sell some of the stock index fund or the bond fund.  The difference between the price at which you sell a security and the price at which you buy it is called a capital gain.  You pay income taxes on the amount of capital gains when they are positive.  In the US, many people pay a Federal tax rate of 15% on capital gains in addition to any state income taxes.  The Canadian tax rate on capital gains is of about the same order of magnitude.

Reduction in Return from Income Taxes

Income taxes, assuming a 15% tax rate, would have reduced your annual average return from 8.4% to 8.1% over the 1980-2019 time period.  Put in dollar terms, you would have had just under $250,000 at the end of 2019 if you started with $10,000 in 1980 and used this asset allocation strategy if you didn’t have to pay income taxes.  By comparison, you would have had about $220,000 if you had to pay income taxes on the capital gains, or 12% less.

As you consider whether re-balancing is an important component of your financial plan, you’ll want to make sure you understand the impact of any income taxes on your investments returns.

Why Only Equities?

You may have been wondering why I was invested almost solely in equities for all of my working life and not in a combination of asset classes, such as stocks and bonds.   My philosophy was that I preferred to use time to provide a diversification benefit rather than an array of asset classes.  By keeping my invested assets in stocks, I was able to take advantage of the higher expected returns from stocks as compared to bonds.

The chart below helps to illustrate this perspective.

Annual Returns - 1980-2019 - Time vs. Rebalance

It compares the volatility of the annual return on a portfolio of 100% stocks over a one-year time period with the same portfolio over five years and with a portfolio of 60% stocks and 40% bonds over one year.

The blue bars on the first and second bars (100% stocks for one year and five years, respectively) are at the same level, meaning they had the same average annual return.  Both the box and whiskers on the second bar are much more compact than the first bar, indicating that the annual returns fell in a much narrow range when considered on a five-year basis rather than a one-year basis.

Cost-Benefit Comparison

Comparison of the first and third bars highlights the cost and benefits of diversifying across asset classes.  The box and whiskers on the 60/40 portfolio are both shorter than the 100% stock portfolio.  That is, there was less variation from year-to-year in the annual return for the 60/40 portfolio than the 100% stock portfolio.   However, the average return (blue line) on the 60/40 portfolio is a bit lower because the 60/40 portfolio had an average annual return that was less than the 100% stock portfolio.

My Focus

The comparison on which I focused in selecting my investment strategy is the one between the second and third bars.  That is, I compared the volatility and average returns of a 100% stock portfolio over five years with the volatility and average returns of a 60/40 portfolio over one year.  As can be seen, there has been less volatility in annual stock returns when considered in five-year time periods.  Yet, the average return on stocks is higher than the average return on the blended portfolio.  Because I didn’t anticipate that I would need to draw down my investment portfolio, I was willing to look at risk over longer time periods and tolerate the year-to-year fluctuations in stock prices in order to expect higher investment returns.

Your time horizon until you might need the money in your investment portfolio and your willingness to wait out the ups and downs of the stock market are important considerations as you decide whether this strategy or a more traditional blended portfolio is a better fit for you.