Don't Sell That Stock!

When not buying is selling

At last year's annual meeting, Chris Davis, manager of the Clipper Fund
(CFIMX), argued that mutual funds essentially sell some of their
holdings in a company when they choose not to buy more, and instead add
a different holding to the portfolio.

He used Warren Buffett's Berkshire Hathaway as an example, saying, "Every year that they didn't buy Coca-Cola, they sold Coca-Cola. Coke became a smaller percentage of their assets as new money came in and didn't go into Coke."

In other words, as new money comes in and is allocated to new
positions, old positions have a smaller and smaller share of the
investment pie. So the influence an old position can have on returns
gets smaller and smaller, just as if some of that position had been
sold.

If you've ever added new money to your portfolio by buying new holdings, the same thing has happened to you.

The big picture

Although we tend to talk
about stocks one by one, the way they're combined in your portfolio is
an equally important part of investing. It's not enough to just add
stocks to your portfolio whenever you run across compelling
investments. You also need to account for your overall diversification,
and the size of the various stakes within your portfolio.

Fail to pay attention to the overall makeup of your portfolio, and
you might end up with a large chunk of your holdings in, say,
oil-related companies or pharmaceutical companies. If the price of oil
plunges, or health-care reform includes draconian price controls on
medicine, those companies could all take a big hit.

But you don't want your portfolio to get too complex, either. If
you've added so many companies that each one makes up just 1% or 2% of
your portfolio, a big home run from one stock isn't likely to make a
huge difference to your bottom line.

That's why, as Davis suggested, adding more money and companies to
your portfolio, and therefore shrinking the power of your existing
holdings, matters.

Perfect your portfolio

Instead of distributing your dollars among the stock that seems most promising, the 56th-most-promising stock, and all the stocks in between, you want to concentrate your investments on your very best ideas -- even when you add money.

Advisors often recommend holding between eight and 12 (sometimes as
many as 20) companies in your portfolio. And that means making sure
that every investment really is one of your very best ideas.

What constitutes a very best idea? For my part, it means stocks with
strong prospects and strong growth. Stocks with solid dividend yields
are a plus, too, and those with low P/E ratios can be bargains.
Screening is a good way to unearth candidates for further research. For
example, here are some companies that popped up when I screened at
Motley Fool CAPS for companies rated four or five stars (out of five),
with revenue growth rates of at least 5%, dividend yields of at least
2%, and P/E ratios of 20 or less:

Source: Motley Fool CAPS. P/E ratio = price-to-earnings ratio.

The Foolish bottom line

You should
always be putting your money into your very best ideas. If a new idea
supersedes an old one, selling a less-good idea to put that money into
the very best idea is the right move. But whatever you do, don't sell
your stocks without knowing it.

© 2009 UCLICK L.L.C.