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Shared and fair: our experts' views

READER PORTFOLIO: Chris Dillow and Keith Bowman give their views
April 23, 2010

The Fair Shares Investment Club has been active for just over a decade and has built up a portfolio worth around £70,000. You can read about the portfolio in more detail here.

Chris Dillow, economics writer, Investors Chronicle:

You say you have a "buy and hold" approach. Whilst there is much to be said for this, it carries a danger which you are close to incurring. This is that you add apparently attractive shares to your portfolio without selling others, with the result that you end up with lots of stocks and thus a portfolio that behave like a tracker fund.

This danger arises from the brutal maths of diversification. Let's say shares have an average tracking error of 30 per cent - that is, there's a one-in-six chance of any one out-performing or under-performing the market by 30 per cent over 12 months. The error will be smaller for larger or less volatile stocks, but larger for more speculative ones. And let's say the correlation between their relative performance is zero; this will be true if your holdings are spread across many sectors, as yours are.

These two numbers tell us that if you own 10 stocks, then you have a 14.6 per cent chance of beating the market by 10 per cent or more over a year. With 20 stocks, your chances of doing so drop by more than half, to 6.8 per cent. And with thirty stocks, they halve again, to just 3.4 per cent.

Everyone knows that holding more stocks spreads risk. What's not so well appreciated, however, is that it reduces the risk of good things happening, as well as bad.

You might object here that stock-picking skill twists the odds in your favour. They do. But not much. Let's say there's a 70 per cent chance that any stock you pick will beat the market. Even then, there's a greater than one-in-five chance (22.6 per cent) of eight of more of your 20 stocks under-performing. With less skill - say, a 55 per cent chance - there's a three-in-four chance of eight or more doing so.

If you want to improve your chances of out-performing the market greatly, you should hold fewer stocks. Of course, this carries with it the danger of under-performing. But this raises another issue: what's the relationship between the club's assets and an individual member's own ones?

The basic principle of thinking about a portfolio is that what matters is your assets as a whole - you needn't worry about some of your assets doing badly if others offset that risk. In this sense, maybe you shouldn't worry about reducing the risk of the club's assets. If members want less risk - and some will and some won't - they can fix this by being cautious with their private assets. This would free up the club to go for growth.

This would have the advantage of allowing you to focus purely on the fun of stock-picking. It has the disadvantage, though, that if you do badly the club might break up acrimoniously - and losing friends is worse than losing money.

Keith Bowman, Hargreaves Lansdown, comments:

This is a relatively diverse portfolio of predominantly blue chip shares has been constructed.

Importantly, although not specifically touched on in the club’s investment objectives, the portfolio contains a number of high-yielding dividend shares such as BP, GlaxoSmithKline and Vodafone. So over the long term, the compounding of reinvested dividends could have a significant positive effect on performance.

The club and the portfolio also touch on another important investment strategy - the benefit of pound cost averaging. This is the practice of investing equal money amounts regularly and periodically over specific time periods. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The aim is to lower the total average cost per share of the investment, providing a lower overall cost per share purchased over time. Although the club does not appear to follow this strategy wholesale, additional investments in Vodafone and Anglo Pacific do indicate some use of the principle.

Further room for applying the cost averaging strategy exists. An additional investment in Aviva, might be considered going forward. The insurance group’s early March full year results highlighted an improving trend in profitability. The company’s capital cushion has been substantially strengthened, whilst management appears confident on the outlook, judging by the above-forecast incresae in the dividend. Analysts are also positive on the company.

The portfolio's weighting in the aerospace and defence sector is also noteworthy. Whilst current consensus opinion in relation to all three constituents- BAE Systems, Cobham and Rolls-Royce - is at least a hold, the sector currently accounts for a heavy 19 per cent of the overall portfolio. That might warrant some trimming.

As for potential new investments, the City is generally positive on betting group William Hill (as is the IC - it's a buy tip). Since the portfolio was submitted for review, Healthcare Locums has attracted a takeover bid.

In all, the portfolio appears to meet the club's long-term objectives, with no pressing issues proving pressing. A holding of higher yielding large cap companies provides a core foundation, with a selection of smaller companies adding additional diversification and interest.