Week 72 - So You Want a Small Portfolio of Only 6 Stocks?

Situation: Stocks are risky, 4-5 times riskier than bonds. To capture the value of owning stocks directly vs. owning a stock mutual fund, you need to distribute the risk by owning stock in a number of companies. Academic studies recommend positions in at least 20 companies representing at least 5 industries. But if you’re just starting out, you’ll want to own only a few stocks. Well, there’s a way to do that: pick stocks to overemphasize safety and underemphasize performance. Instead of buying the 1/3rd Lifeboat Stocks and 2/3rds Core Holdings that we recommended (see Week 3), reverse that ratio for a small portfolio of 6 picks and go with companies that have the best credit ratings.

We first identify those that have a AAA credit rating (which is better than US Treasury Bonds with have a AA- credit rating). That AAA credit rating means the risk of bankruptcy is negligible: S&P can identify no concerns or issues that might herald a risk of bankruptcy. We’ve found there are only 4 such companies: Exxon Mobil (XOM), Automatic Data Processing (ADP), Johnson & Johnson (JNJ) and Microsoft (MSFT). To get you to our goal of 6 stocks, we’ll add the next safest company (in our opinion): Wal*Mart (WMT), with a AA credit rating. Then we’ll add the safest utility (in our opinion) that has its bonds guaranteed by a state government: NextEra Energy (NEE), with an A- credit rating.

Given the size of your portfolio, you can’t afford to be concerned about performance. Nonetheless, the 6 companies we’ve identified have performed as well (in the aggregate) as the least costly S&P 500 Index Fund (VFIAX, in the attached Table). More importantly, this “safe” portfolio of 6 stocks was harmed much less than VFIAX by the Lehman Panic.

But now you’ll want to know how these 6 stocks have performed compared to bonds, which we’ve recommended you own in a 1:1 ratio with stocks (Week 3). Bonds did better, as represented in the table by the T Rowe Price New Income Fund (PRCIX). You’d have also done better by avoiding those 6 stocks and holding the lowest cost balanced fund that has at least 50% of its asset value in bonds: the Vanguard Wellesley Income Fund (VWINX, in the Table).

Bottom Line: Owning individual stocks is a time-consuming hobby because you’ll soon realize that you need a baker’s dozen of dividend growers before you’ll sleep well. But there is a way to start with a portfolio of only 6 stocks where the gains are likely to be about as good as the S&P 500 Index and the pains are much less. But a more economical use of your resources would be to hold a low-cost bond-heavy balanced fund like VWINX, and you’ll probably make at least as much money going forward.

In future weekly posts, we’ll distinguish between blogs that feature ideas for investment performance vs. those that feature ideas for safety. In our closing statements, we’ll include a ratings scale of 0 to 10. An number between 7 to 10 will be for discussions that emphasize performance, while 1 to 3 will be for those that emphasize safety. Bear in mind that out-performance cannot be achieved without sacrificing safety but out-performance yields a bigger nest egg for retirement.

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