Holding a concentrated portfolio that contains only a few stocks is a two-edged sword. If you pick the right stocks, they can pay off in spades. But if you don't, you might be taken to the poorhouse.
It's one reason why I'm very pleased to say that my strategy lab model portfolio, which contains nine value stocks from the United States and Canada, has done very well indeed. It grew by a total of 33 per cent since it was launched (September, 2012) through to the end of September, 2013.
By way of comparison, it outperformed the low-fee index portfolio used by my colleague Andrew Hallam, which climbed almost 11 per cent.
The value portfolio focuses on only a few stocks in an effort to guide you to the very best. I hope that you'll consider adding some of them to your already well-diversified holdings.
But a handful of people might be tempted to clone the portfolio and forsake all other investments entirely, which worries me.
It's one reason why I decided to keep a large portion of the portfolio's assets in cash. The cash blunts some of the volatility generated by the stocks. It also helps to encourage a more balanced approach to asset allocation. After all, the vast majority of investors should own more than a few stocks.
When it comes to asset allocation, I like the recommendations offered by Benjamin Graham in his book The Intelligent Investor. The famous money manager suggested holding no less than 25 per cent in bonds and no less than 25 per cent in stocks.
An aggressive investor might decide to put 75 per cent of their assets in stocks and 25 per cent in bonds, while conservative investors should do the opposite. But most people are best advised to go with something in between. For instance, balanced funds often hold equal amounts of both stocks and bonds. Alternately, a mix of 60 per cent stocks and 40 per cent bonds is quite common.
I started my value portfolio off with 30 per cent in cash, which puts it on the aggressive end of the spectrum. But its stocks rose sharply over the course of the year and its cash levels slipped to 24 per cent of assets by the end of September. That's outside Mr. Graham's limit.
However, the imminent takeover of Dell Inc. should push the portfolio's cash levels back up to 33 per cent, barring any other significant changes.
While Mr. Graham liked bonds, I went with cash for two main reasons.
First, the model portfolio is only allowed to hold 12 securities at most and I wanted to leave as much room as possible for stocks. Second, the yields on longer-term bonds weren't particularly good last year and they haven't improved much since then. Even worse, most investors face stiff fees when buying bonds or bond funds. Instead, I tend to favour good high-interest savings accounts or GICs. They might not pay much these days, but they're there for safety's sake.
A secondary argument for holding a reasonable amount of cash arises from the market's lofty valuation levels. Simply put, stocks are relatively expensive. For instance, professor Robert Shiller's cyclically adjusted price-earnings ratio for the S&P 500 currently sits at 23.5, which is well above its average of 16.5 based on data from 1881 to 2013. As a result, investors should prepare themselves for the possibility that stocks might decline to more normal levels – or even worse.
Which is all to say that cash isn't trash. It can be used to help soften the volatility generated by concentrated portfolios and it provides a hedge against an overvalued market.