I have a port that does particularly well and I want to make it as much a part of my total portfolio as I safely can.
Can I safely increase the holdings of a stock in the SP(500) and SP(400) universes compared to a smaller-cap stock?
If so how much more concentrated that a small- or micro-cap stock? What total concentration would be reasonable for a single stock in the SP(500) or SP(400) universe?
Thank you in advanced for any suggestion?
Jim,
What I would say is mostly yes but sometimes no. In my experience larger stocks are less likely to a) report massive accounting fraud (it still happens, i.e. Enron), but it’s less likely. And less likely to have huge earnings misses (again it can happen). And huge scandals or major news surprises - or acquisition bids, etc - fewer big events. So, 50% plus 1 or 2 day drops (or gains) become less and less likely for a single stock as it’s market cap rises.
Large cap stocks have lower ‘beta’ than small caps (even if we think Beta’s meaningless it is a rough measure of volatility). The Beta for the R1000 ETF is about 1. For the R2000 ETF it’s about 1.5. For microcaps, 1.31. So microcaps are ‘less volatile’ as a group than the R2000. Midcaps about 1.18. Can just look these up on I-shares or do your own tests with the screener.
In terms of the SP universes, they also have some earnings consistency and minimum trading liquidity constraints that help ensure some minimum quality/profitability and share availability. So, a system of 10 stocks from these universes is somewhat less likely to have a big down (or up) day. This can be particularly true in times of severe market distress.
But the volatility of a portfolio of 20 stocks from the various universes may not differ at all depending on the market regime we’re in. And any 5 or 10 stock system will still have a lot of ‘style drift’ around the underlying ranking and/or ‘random noise’ as the single largest 6 month or 12 month return driver. Everyone constructs their port’s differently, and some people are fine with 5-10 stock ports. Some need 30 stocks to feel they will track their return drivers and feel ‘safe.’ I don’t really like 5 and 10 stock systems. But do trade some 10 stock systems. I try to get to a min. of 30, ideally 50 trades / year per system.
Having said all that, there are big name value investors managing billions who roll along for decades with 80% or more of their money in 5 to 10 positions. So, it can be done. Buffett did this for decades. I use a 2% rule (no more than 2% of my port. in any single position). That’s somewhat conservative in the trading world. For shorts, it’s 1%.
It’s also possible to argue small stocks are safer (more transparent and understandable business models, fewer really sophisticated investors playing in them, fewer pattern traders, options and futures traders and the like manipulating their prices, etc, but I’ll leave that for another day).
Good luck,
Best,
Tom
Thanks Tom!
That helps.
Jim,
I agree with most of what Tom said above except for his dislike for 5 stock Ports. I feel that four good 5 stock Ports using 4 different trading approaches is far safer than any 20 stock port based on a single trading system. That is easy to test using the Book Sims. Take any of your 5 stock systems and run them in a Book simulation to see for yourself.
To answer your question above, add your large cap system, your mid cap system, your small cap system, and your micro cap system into a book with equal weights. Then run a new book using weighting factors of 2.5, 2.0, 1.5, & 1.0 respectively to see the effect of using higher holdings as the cap size increases. Then play with the weightings until you are happy with both the higher holding sizes and the performance compromises.
Thank you Denny! I agree. That is how this how this got started and that is my ultimate goal.
Briefly, I found that if I run my best 5 stock sim with Universe(SP500) = false and Universe(SP500) = False, the sim does just as well. Then if I run a modified Ranking system on just the SP(500) and SP(400) Universe this port does well also.
Great! So now I can have a 10 stock book with no repeats and pretty well diversified across market caps.
My problem is that the port does well both in and out of sample. But the backtests for the smaller-cap stocks are not reliable: I’ve been been trying to tweak the system to get 2 different 5 stock ports for a while. I attribute this to the use of estimate revisions. Whether this is the reason or not, I am not sure that the port will do as well if I change the universe. It could do better without the large-caps, however: probably will.
I was considering whether I could tolerate some repeats in the more liquid and less risky SP(500) and SP(400) until I got some out-of-sample results.
Great point and I agree 100%.
Jim,
Run them in a book. If the performance is improved then you can tolerate some repeats. You don’t even have to know if there were repeats (although that is easy to check by comparing the All Transactions).