How to build your penny share portfolio

I guarantee that if you took a portfolio of ten shares to a professional financial advisor or fund manager he would tell you that you were taking much too much risk by owning so few. He would start blathering on about ‘share specific risk’, ‘market risk’, ‘interest rate risk’ and ‘event risk.’ He would tell you that you really should own many more than ten shares. The real risk is that you might believe him!

The fact is that you only need ten shares to have a sound portfolio, and if you start adding lots more shares it makes damn all difference to your ‘risk’.

Let me give you some simple rules of portfolio management.

Don’t hold too many shares

The risk of your portfolio is determined by how many shares you own, by how much they swing around and by the extent to which they all tend to move in the same direction at the same time. All this multiplies up to something called the standard deviation of your portfolio. Now assume you have one share with 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.

But now listen to this: 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 housebuilders. Ten shares will do it. Have a few more if you really want to, but try and work with an upper limit of 25 or 30. Buying a whole lot more is going to achieve nothing, except a lot of extra work and dealing costs!

Of course, if you hold ten shares in your portfolio and one of them halves in value, you lose 5% of your money. But it works both ways. You want your winners to count and to make a real difference. Professional fund managers typically have 70 to 120 shares in their portfolios, and their idea of a ‘concentrated portfolio’ that holds only those companies in which they have ‘maximum conviction’ is one that holds about 40 shares. But this is still too many. As I said earlier, fund managers have hundreds of millions of pounds to invest, and this dictates that they need to spread it about – and then of course come up with some post-rationalisation. But you should not be taken in by this nonsense.

So rule one of portfolio management is this: don’t hold too many shares. I would aim for something between ten and 30.

Spread the risk

It should be pretty obvious that if UK house prices are falling, you don’t want to be a housebuilder. House prices fall together around the country, and there is no place to hide. So if you have ten shares in your portfolio and they are all housebuilding companies, you are going to suffer.

The same applies to any industry or sector. From the start of the 2000s, technology shares did very badly and mining shares performed very strongly. In the last few years these trends have reversed. No sector performs consistently, and all of them will experience cycles of underperformance and outperformance.

In order to dampen down the volatility of your portfolio you need to make sure that you invest in several different sectors.

Don’t over-trade

I cannot emphasise enough the importance of keeping your costs down to a minimum. In by-passing the fund management industry and doing it yourself, you are going to make a huge difference to your investment return. But you must also make sure that you do not run up unnecessary dealing costs. Each time you buy or sell a share it is going to cost you in dealing charges. But to give you an idea of how significant this is, take a look at these tables:

Portfolio Size £5,000

Annual turnover Number of shareholdings
5 10 15
20% £29       (0.6%) £53      (1.1%) £77     (1.5%)
50% £72.50     (1.4%) £132.50    (2.6%) £192.50   (3.8%)

Portfolio Size £25,000

Annual turnover Number of shareholdings
5 10 15
20% £73       (0.3%) £97           (0.4%) £121        (0.5%)
50% £182.50    (0.7%) £242.50      (1.0%) £302.5     (1.2%)
100% £365       (1.5%) £485         (1.9%) £605        (2.4%)

Portfolio Size £100,000

Annual turnover Number of shareholdings
5 10 15
20% £148        (0.1%) £196         (0.2%) £292         (0.3%)
50% £370        (0.4%) £490         (0.5%) £730         (0.7%)
100% £740        (0.7%) £980         (1.0%) £1,460       (1.5%)

 

Each table shows the total annual dealing costs (including stamp duty), based on an assumed number of individual shareholdings and annual turnover. So if annual turnover is shown at 20%, this implies that 20% of your holdings are sold each year and replaced by others. In italics, I show the percentage of the total portfolio value that is lost through dealing charges. I have assumed a £12 per trade dealing cost. So, taking the first example in the first table: if you have a portfolio of £5,000 split between five shares, and have an annual portfolio turnover of 20% (ie you sell just one share and replace it with another) the annual cost of running your portfolio is just 0.6% of its total value.

If you have your money managed by a City professional you will pay about 2.5% per year for the privilege. But of the 27 theoretical cases set out above, in only five does the annual charge exceed 2.5%. The message is two-fold: you should not overtrade, but also, as your portfolio gets bigger the cost of managing it becomes a progressively smaller percentage.

As you can see it is easy to undercut the City, and this will make a huge difference over time. Remember the maths. An investment of £10,000, which earns an underlying return of 10% over 20 years, will grow to £42,478 after annual charges of 2.5%. But if you have limited the annual charges to just 1.5%, you will have £51,120. That is a benefit of nearly £9,000 just from choosing to manage your own share portfolio!

One place you can manage your portfolio is on our easy to use Red Hot Share Dealing service, click here for details on how you could open a share dealing account or Isa account in minutes .

Keep things in proportion

Your portfolio of shares should mirror your own convictions. If you start by picking ten shares and you are equally keen on all of them, you should invest the same amount into each. That is easy, but of course the shape of your portfolio will move around from the day that you start. Suppose that one of your ten shares doubles while the price of all the others stays the same. Then the proportion of your portfolio in this one share will be not 10% but 18%. Are you so keen on the prospects for this one share that you want to have this much of your fortunes staked upon it?

There is no golden rule here. I am a fan of letting my winners run and discarding my losers. However, it is a good idea for your portfolio not to become dependent on a single share. Taking some profit whilst retaining a good sized holding is a prudent course and provides funds for fresh ideas.

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Stay cool!

How often should you look at your portfolio? Although there is no harm in following all the stock market news as it happens, you do not want to fall into the trap of over-trading. On the other hand, a policy of neglect is no good either! I would suggest that you review your portfolio every three months. That is not to say that you should do nothing between these review dates. If a great opportunity to buy or to sell arises in the market you should grab it. But if you just fire off your trades at random, your portfolio will end up in a mess.

So every quarter take a look at it. If you have a portfolio with an online broker then print it out, sit down and study it. Are you holding too few shares or too many? Have some of the holdings become alarmingly large, or so small as to be insignificant? Does your portfolio really mirror your convictions? Or are you holding some shares which seemed a good idea when you bought them but are now in the portfolio more in hope than confidence? Do you have a reasonable spread of risk, or do you have too many shares in a similar sector – mining, say?

You may decide that your portfolio is in perfect shape, in which case, great! But you may find that you want to make a change or two. Nothing wholesale. Just one holding trimmed and another one added to, perhaps. The important thing is just to stay in control.

In Red Hot Penny Shares, the place to find growth companies on the stock market, we run a virtual portfolio for our loyal readers. You can get access to this portfolio, the online archive of issues, and all the latest research as part of a 90-day trial. Discover my latest recommendations and start your trial by following the instructions here.

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