You asked… here’s my answer

You asked… here’s my answer

I’d like to talk about a topic I hear about a lot in subscribers’ emails.

Subscribers ask how much they should allocate to each stock; or how many stocks they should own; or how to keep down dealing costs in their portfolio.

There’s one big answer to all three of those questions…

Risk vs. Costs

When you’re deciding how to build your portfolio of penny shares, you have three goals.

The first is to return as much as possible. That one is obvious. Second, you want to minimise your risk, so that the overall value of your investments stays fairly steady and doesn’t give you heartburn. And third, you want to keep dealing costs and tax burden low.

The problem is that the last two of those goals are in tension. It can be hard to keep dealing costs low and minimise risk at the same time.

What do I mean by risk?

Well, in this context risk means “the propensity of your portfolio to move about in value”. All things being equal, you want less risk. The more risky your portfolio is, the less sure you can be of its value in the future.

Risk has three elements:

  • How many shares you own (the more shares you own, the less risk)
  • How much they swing around (junior gold miners swing around more than British Gas)
  • The extent to which they all tend to move in the same direction at the same time (a bucket of companies in different industries is less risky than a bucket of bank stocks, for example).

All this multiplies up to something called the standard deviation of your portfolio. Standard deviation is “the risk number”. The lower the standard deviation, the better.

Assume you have one share and it has a standard deviation of 25. If you add another share – in a different sector – the standard deviation of your two-share portfolio falls to 20.2. With five shares the standard deviation is down to 16.6 and by the time you have ten the standard deviation of your portfolio falls to 15.2.

The thing is, if you have 100 shares the standard deviation falls to only 13.9 and even if you have 200 shares the figure is still 13.8.

You need not understand exactly what is meant by standard deviation. The crucial message is that after a certain point you can go on adding new shares to your portfolio, but they will make practically no difference to its ‘risk’ – in other words the extent to which it is likely to fluctuate in value from one day to the next.

You do not need to have a huge long list of shares. Just make sure that they are a good mixture, and not all, for instance, gold mines or house builders. Ten shares will do it. Have a few more if you really want to, but try and work with an upper limit of 20 or so. Buying a whole lot more is going to achieve nothing, except a lot of extra work and dealing costs.

Now, the lower your risk the higher your dealing costs are going to be. And vice versa.

Why is that? Well, it’s because stockbrokers charge a flat fee per transaction, among other fees. So the fewer transactions you make, the lower your dealing costs are going to be. But the higher the number of transactions you make, the more you’ll pay in costs.

For example, if a broker charges £10 per trade and you decide to divide your £3000 pot into 20 shares, your dealing costs are going to be 20*10= £200. But if you put the whole £3000 into just two shares, your dealing costs will be £20.

£200 adds up to 6.66% of you the value of your portfolio, on top of spreads and whatever else you have to pay. So you’ll have to make 5-10% on your investments just to stand still. All things being equal you’ll want fewer transactions to keep costs low.

But as I’ve just explained, you only make your portfolio less risky by spreading your money across more positions. If you put your £3000 into two shares, you’re at their mercy. A bit of bad luck could seriously hurt you.

Better to spread your money into a number of shares. On average your returns won’t suffer. But you’ll have less heartburn because the overall value of your portfolio will be more stable. All things being equal, you’ll want more shares to reduce your risk.

So that’s the tension. Fewer transactions for lower costs; more shares for less risk.

So the question is, how diverse is diverse enough? The answer is, as I’ve mentioned above, 10. A portfolio of 10 shares are much less risky than a portfolio of two shares, and only a tiny bit more risky than a portfolio of say 100 shares. Around 10 is the sweet spot.

What about dealing costs? For small caps, you’d like your overall dealing costs to be 2% or less. That’s a reasonable amount to pay.

So there you have it. If you have a large amount of money to invest in small caps, buy the 10 shares you’re most excited about. And don’t pay more than 2% in fees.

If you’re just starting out with a small amount to invest, I would recommend you prioritise keeping dealing costs low. Maybe you could start out with only one or two positions and then gradually build up your portfolio over time by adding new positions. That way your dealing costs will be low, and your risk will gradually decrease.

I hope that’s helpful. I get a lot of questions around this topic so I know it’s important to you. If there’s anything further you’d like me to cover, just drop me an email at edgeofthemarkets@agora.co.uk.