The 6 Principles of a Rule Breaker Portfolio

By now, you should know what Rule Breaker companies look like. And you should know what it means to be a Rule Breaker investor. In this episode of Rule Breaker Investing, it’s time to look at what a Rule Breaker portfolio looks like, how it is built, and how it is stewarded.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on January 13, 2021.

David Gardner: It’s not often that I come up with a new list of six Rule Breaker principles. The first was published in 1998 and it was of course, the six Rule Breaker company traits. The six traits that we looked for in stocks that caused us to recommend the companies that we do. Well, 23 years later, I’m still using the very same list of six traits as any Rule Breaker member knows, as any Rule Breaker Investing podcast listener of any vintage will recognize. Why? Well, they work. Years later, I decided to come up with a second list of Rule Breaker principles. This time, it was the six habits of the Rule Breaker investor. These were not about the companies we’re buying, that was the first list. These were about you and your behaviors. I came to recognize that even if someone has a great list of stocks to buy, if they don’t properly know how to invest, how to treat a winning stock, our good advice could end up as somebody else’s bad outcome, so the six habits of the Rule Breaker investor were born, and that was the second list. Years later again, well, here we are. I got it in my head that there’s another set of six Rule Breaker principles that can help the individual investor. It’s probably for most people the biggest gap in their learning. I think it’s the most relevant new thing that I can bring you. Now, after the six traits of Rule Breaker stocks, the six habits of Rule Breaker investors. These aren’t about your stocks, and they aren’t about you. Nope. They are about what you and your stocks combine to become a portfolio, your portfolio. It’s time this week for a new coming out party, the six principles of Rule Breaker portfolios, only on this week’s Rule Breaker Investing.

Welcome back to Rule Breaker Investing. I hope you enjoyed last week’s podcast; if you didn’t get a chance, and you want to hear me talk about my six biggest losers, my worst stock picks of the last three years, well, that’s exactly what David’s Biggest Losers: Volume 6 offers you from last week. The reason it’s Volume 6 is because it’s an annual tradition. I start each year, week one, talking about my biggest dogs of the previous three years. So please, enjoy. Before we get to the important topic for this week’s podcast, six Rule Breaker principles for your portfolio, I do want to flag next week’s podcast. Yeah. Every 10 weeks, I pick five stocks in this podcast for free. It’s my five stock samplers and next week will be the 28th in the history of this podcast. Yeah, 28 weeks have happened at least 10 times in the six years we’ve been bringing you Rule Breaker Investing. The 28th will be unveiled next week. I already know my theme and I’m rubbing my hands together with excitement and joy, thinking about next week’s five stock sampler. Well, also speaking of joy, I’ll be reviewing 25 stock samplers for January’s past, including my one from January 2020, a year-ago, Five Stocks that Spark Joy, spoiler alert, boy, have they sparked some joy. We’ll do our review-a-palooza next week, as well as unveil our new five stock sampler.

But now, to this week’s important topic — I keep saying important because really this week is much more important than next week. Next week, I’ll be picking some more stocks. We’ll look at past five stock samplers, we’ll have fun learning together. But, the rare times that I’ve dreamed up and deployed lists of six Rule Breaker principles, which I spoke to at the very top of the show, the rare times those happened, I think deserve a double underline. In particular, this week’s show has come about, because my observation from having been a Motley Fool employee for 28 years now, is that one area that we probably haven’t addressed quite enough, which has caused lots of mailbag questions on this podcast, and beyond just this podcast, many members’ services questions that will get phoned in every day. No doubt, we’ve spoken in speeches at Fool Fests about these topics and the topic of how to build and maintain a portfolio will always be timelessly important, but I don’t think we’ve probably addressed it in a way that everybody can walk away with some principles and learn from.

In some ways, we create a problem. It’s a good kind of problem to have, but we give you some stock picks, we give you the habits to follow as an investor, and if you prosper, you end up with a great portfolio, but then you have questions like, ”Well, how many stocks should I have in my portfolio?” Or, ”Should I add new money to existing stocks, or should I add it to new ideas that you guys have just told me about?” The list goes on of the repetitive questions that we’ve answered, not just again here on this podcast every month in mailbag, final week of every month, coming up in a couple of more weeks, not just here on Rule Breaker Investing, but certainly so many times on our radio show back in the day on NPR right through to member meetings, all kinds of questions around people’s portfolios.

Darn it, why wouldn’t you have these questions? Because as I mentioned at the top, when you mix the powerful components into a cauldron of your stocks and your money and then your ideas, and you start swirling them about, they become a portfolio. Everyone looks different. The taste of every cauldron brew is unique. It’s very hard to answer definitively how all of us should manage each of our respective portfolios. In a lot of ways, I think our company, The Motley Fool, has done yeoman’s work trying to help people figure it out, but maybe we haven’t been prescriptive enough at a high level. That’s why I thought to present to you my six principles of Rule Breaker portfolios. There’s something about the numbers six that I like. It divides very evenly into two groups of three, which is exactly how I’ve constructed these principles. We’ll have three to build your portfolio and then, No. 4, No. 5, and No. 6, three more, to maintain your portfolio.

Before we get to these six, I want to issue three, I’m not going to call them disclaimers, but we’ll say qualifiers. The first one is this is a draft. I’m sharing with you my drafted work. I’m asking you, do these help? Am I missing anything? Maybe I’m missing something big. This is a draft and I would love to hear back from you, particularly on this month’s mailbag as to whether these are helpful for you, these principles are helpful for you. If you want to help me out by tweaking some language, adding or subtracting very open to your input.

Qualifier No. 2. Well, as I named them before, these are principles. This is not an exhaustive list. Reflect back on our six company traits, our six Rule Breaker company traits. Things like top dog and first-mover in an important emerging industry, which I’ve been rocking for almost 25 years now, those six taken together are not exhaustive, they’re just traits or principles. There’s certainly other things that we look at in companies, much is left unsaid. That’s true, not just of the six Rule Breaker company traits, but from some years ago, of course, our six Rule Breaker investor habits. Rule No. 1, let your winners run high. That’s No. 1. I hope you know No. 2. No. 2, add up, don’t double down. Those six investor habits, which you can go back and relisten to anytime through this podcast, those six habits are not again exhaustive. Much is left unsaid there, they are principles. That’s true of these portfolio principles as well. I can’t think of a way in six principles, with simple language maybe one sentence for each. I can’t possibly solve everybody’s portfolio construction problems, but darn it, I sure do want to speak to how I think you can best get started building and then of course, maintaining your portfolio. Hence, these six principles.

Qualifier No. 3, the primary emphasis here is on building and maintaining. I’m not as focused with these principles on selling off your portfolio or shutting down your portfolio, in retirement or at the end of life. That might take some whole separate list one day or some separate thinking or framework. It certainly will occasionally color what I’m saying here. But the real focus of my six principles of Rule Breaker portfolios is on the building of it, and the maintaining of it each portfolio. There are my three qualifiers. This is a draft. These are principles, they’re not exhaustive, and the primary emphasis is on building and maintaining. Well, without further ado, I say let’s get started. Let’s play some appropriate music to get us ready for the six principles of Rule Breaker portfolios.

That theme will probably come back to mean something in a little while, but first, let’s get started with the Rule Breaker portfolio principle No. 1. This one might end up on my grave stone. It’s probably my best-known, most used line by others, and so how could I not make Rule Breaker portfolio principle No. 1 this simple dictum? Make your portfolio reflect your best vision for our future. I got a note in the past week from a friend and a prominent investor, somebody that some of you would recognize as a public investor. I’m not going to name who it is, but he did drop me a lovely line. He said he reviewed that line of mine once again and, maybe it was a new year thing, he’s changed how he thinks about investing, which will influence his funds and the advice that he gives. I’m guessing what jumped out to him was this concept that everything is connected. The money that you have saved, congratulations, if you’re listening to us, is going into companies that you esteem. Over the course of time, you see a better world as each of those companies prosper. Sadly, not all of them will, but the best ones will, and your capital and mine is constantly shaping the future in ways that are invisible to us often.

Many people don’t think much about it at all, some of them are cynical, but I certainly won’t call all of them cynical, but some of them are just in this thing for the money. If using algorithms and high-frequency trading they could become a billionaire in the next five seconds, they’d hit that button, and I realize the attractions of making money. That’s what a lot of us are trying to do in this world, but then the question comes, what would you do with it once you’ve made it? I sure hope that the act of making it and what you will do with your money from your portfolio, dear listener, will create a better world for me, your kids, and you. Make your portfolio reflect your best vision for our future. The Business Roundtable made waves a couple of years ago when it acknowledged what conscious capitalists have been working toward for more than a decade when it stated that the purpose of business is no longer merely to reward shareholders or maximize profits, the purpose of business is to reward all stakeholders. It was much brooded about in the headlines, what the Business Roundtable had said, and certainly, as it’s an umbrella organization and a lobbying organization for big business, I’m sure that there are some companies that were truly already doing that, and many others that are purposing toward doing it better. I’m sure there’s probably some other companies that just signed their name and aren’t doing much at all.

But let’s focus on the good work being done by so many companies worldwide, and let’s make sure that you and I are getting our portfolios into those companies. You should be able to look up and down your portfolio as I did with one of my sons earlier this week and say, “I love and esteem all of the companies in this portfolio.” Some of them had a great year last year, some of them might be well behind the market, but you should be able, again, to look up and down that portfolio and feel kinship, excitement, and belief in every one of those companies, because darn it, if your capital succeeds with that company and that company grows in the world, let’s make sure it’s a better world. Now, I have to add, each of us has our own views of the future. This may sound crazy, but I truly do believe it’s an ethical and consistent notion that if a friend of yours loves smoking, that it is a perfectly fair approach for them to add Philip Morris or a tobacco company into their portfolio. For them, they love that product. Yes, that product causes a lot of harm, I think that’s been well-documented and guess what? Lots of other products create at least a little bit of harm too. I love my sugar sodas, but I’m pretty sure I shouldn’t be drinking them every day, and indeed, I don’t. There are greater and lesser degrees of harm in this world, but what harms you believe are truly toxic and what harms you actually invite willingly into your body, that’s your call, isn’t it? So, I think it’s entirely consistent to make sure that the money that is invested in your portfolio is probably reflecting in a lot of ways how you spend your money toward the world that you want to live in, that you’re creating through your spending and your investing.

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I loved getting that note from my friend earlier this week. I refer to that process as switching on. We all come from different cultures, we all come from different backgrounds, but some of us at a certain point start to realize it’s about more than just the money, more than just the portfolio performance. Your portfolio is connected to mine, and together, we make a market, and together, all of the markets make the world in which we live. That’s why I’m so focused on the purpose of the companies that I’m invested in. To close, before we move onto No. 2, remember that those six traits of Rule Breaker companies often are reflected in the kinds of companies that I buy and put into my portfolio. So, if you’re wondering how to make your portfolio reflect your best vision for our future, which companies exactly you might want to go about selecting, I refer you back to our six Rule Breaker company traits. Everything is connected.

Principle No. 2, for your Rule Breaker portfolio, No. 2, name its purpose, and will there be money coming in or not? I stuck two ideas into that one principle, let me pull them apart for a sec. First of all, know why you’re doing what you’re doing. What is the purpose of your portfolio? Is it to turn your grandson onto investing for the first time? Is this your nest egg that you’re growing very carefully, I hope, in concert with your spouse or partner? Is it a fun, crazy portfolio you’re throwing cryptocurrencies in, you’re just going to be experimenting, learning, speculating, and having a good time? Know why you’re doing what you’re doing. There’s a great reason that so many of us think about the purpose of our companies. It’s because once you’re aligned around that purpose with all the other people at your company, you’re probably going to succeed much better at actually fulfilling that purpose when you’ve stated it upfront. So, I think it’s a great idea to state the purpose of your portfolio, maybe even name your portfolio, if you haven’t already, with the name of your purpose so that you don’t forget, and that’s something else I wanted to say.

Sometimes we can lose track if we haven’t stated our purpose in the first place and named things, we start to get carried away. After a great market year, we might start speculating like crazy, “That wasn’t the initial goal of that portfolio,” so it serves as a north star to bring us back and guide us again thinking through our purpose and name that portfolio and not forgetting that portfolio, based on the conditions that have occurred since, so it’s a great grounding mechanism. But a second thing that can sometimes happen, talking at the other side of my mouth, is sometimes, the purpose of things evolves. After all, I’ve seen that at The Motley Fool, we’ve had, I think, three different purpose statements over 28 years. Sometimes it makes a lot of sense to look at the world and say, “Do we need to change our purpose?” Looking at your portfolio, does it take on new meaning or new possibilities? Well, you should evolve that as needed. Even though, here in this build your portfolio, these three principles I’m leading off with, I’m talking importantly about being grounded and stating purposes and being true to them, from the very start, do realize that sometimes the best decision you can make is to evolve that purpose. The best way you’ll recognize that you should do that or need to do that is that you’ve been conscious about it from the very beginning. So, name its purpose, and then part No. 2, will there be money coming in or not? I think the biggest dividing line in a world in which everybody tries to throw things into one of two buckets-

The biggest dividing line for most portfolio types that I’ve seen over years of working at The Motley Fool are the portfolios that have new money coming in and those that do not have new money coming in. How you treat those two similar but rather different creatures is important. Some years ago, with the debut of Motley Fool Supernova, which was within the last decade, a lot of my focus was creating new missions, new real money portfolios in Motley Fool Supernova. I know some of you are Supernova members or have been in the past. You’ll recognize that the two real money portfolio types that we proposed for Motley Fool Supernova were the Odyssey sets of missions, amusing space missions for fun. It’s basically real money portfolios. The Odyssey portfolios, and then the Phoenix portfolios. The Odyssey portfolios were for Odyssey, were for people out there on an adventure, younger people who had a lot ahead of them with new money coming in all the time. Each of those Odyssey missions, which were very successful, had regular money coming in and our teams were proposing, investing those on a regular basis. They’d accumulate that money over a month or a quarter and then they would invest it and just keep investing it in. Certainly for most of us as adults, if we started young enough in our lives, the majority of our investing is in that mode. Regular money coming in, want to be allocated to companies, gets it invested. Then the Phoenix side of things, Phoenix of course, the bird, which near the end of its life, lights up and is reborn from its own ashes. That was a wonderful metaphor that we had for people who are older in life, maybe just having retired. You’re reborn in the sense at that point, but you have a different approach now, because you don’t have new money coming in, you’re probably not getting a salary anymore and you’re managing that portfolio. I truly believe that Rule Breaker Investing can work for both. History will show for anybody who has gone back to see the performance of all of the Odyssey missions and all of the Phoenix missions that we want the market with.

They were very different. One of them achieved a lump sum and then never got any new money in after that. The Phoenix portfolios, we did really well with that, but how do you invest that? As those of you in retirement know, it is very different from this expectation that you will have more money coming in next week, next month, next quarter. In a later principle, in fact, I reached out to Jim Mueller who helped run the Phoenix mission. I will be sharing some pointers and tips from him. Enough for now for principle No. 2, name your portfolio’s purpose and will there be money coming in or not? Because surely that will affect how you manage your portfolio and its purpose.

Principle No. 3 for your Rule Breaker portfolio. Simple words for this one, fair starting line. Three words for principle No. 3, fair starting line. My mental image here hails back to the music that Rick Engdahl, my producer, he kicked us off with earlier because we’re getting to the horse race tracks. Here comes my Kentucky Derby analogy. I’ve used this a number of times in the past in this podcast, but now I’m really cementing it here with my six principles of Rule Breaker portfolios. Fair starting line. Please picture what happens at the start of the Kentucky Derby every year. They are usually something like 20 different horses, but they’re in 20 different gates, each equally sized and each equally distant from the finish line. All 20 of those horses have a fair starting line. This is principle No. 3, this is the build principle. We’re talking about launching your portfolio. The mental image that I want you to have is that you should evenly and equally allocate to all of your stocks as you start a portfolio. Truth be told, longtime track betters will recognize that a horse that’s in gate No. 1 does have an advantage over a horse in gate No. 10 or 17. Turns out, starting near the inside is a small advantage. If you want to give a slight nod to one or two of your 20 stocks that you start your portfolio with, I guess I’m OK with that, but really my line in the sand here is that fair starting line.

I pick five stock samplers every 10 weeks on this podcast. My newest one comes next week. At no point have I ever said, here are the five stocks, but here is the one that you should really load up on. I don’t think I would have done nearly as well had I done that guesswork. Yes, sometimes we can have intuition and sometimes your intuition is even right. That this or that stock of the 20-year so that we buy to start a portfolio might be better than the others. I’ve never rested too comfortably on those assumptions. My five stock samplers, which are basically mini portfolios, are always equally weighted, fair starting lines. By the way, it’s fun to note that each of those five stock samplers is named and has a purpose, which hails right back to the previous principle I shared with you, principle No. 2. My five stock samplers in a microcosm as a fractal not only have been spectacular performance, but also represent in a lot of ways a small, miniature version of what I’m sharing with you this week. Line up your horses in their gates, principle No. 3, and hold onto this horse racing analogy because a couple of more principles will be returning right back here.

The last thing before I close up these first three. I’ve hinted this way, I think as you’re starting a portfolio, I really like a minimum number of stocks, 20. In fact, if you’re familiar with my six habits of Rule Breaker investors, you’ll recognize that principle No. 5 is max 5% allocation. What I’m saying with that one is you should be in the habit anytime you add a new stock to a portfolio in future, never make that more than 5% of the portfolio. If you think about the start of a portfolio, if we’re holding to that max 5% allocation, that implies directly, and I mean to do so, you should have 20 stocks in that portfolio. If you have 15, that’s a perfectly fair start as well, maybe even 10. In an age where increasingly, you can buy fractional shares of many different stocks, particularly here in the U.S. I hope this goes worldwide, you can basically allocate any amount of money into any stock. The price per share no longer matters. By the way, often you have no commissions anymore, at least here in the U.S. as well. Darn it, you owe it to yourself to create a fair starting line and from the very first day build a portfolio of at least 20 of your favorite companies that will make your portfolio reflect your best vision for our future. So yeah, I like the number 20 to start a portfolio. It really does work here in 2021.

Had a funny conversation with my witty cousin earlier today. I said, “Happy New Year, Garrett,” and he said, “Well, I’m not so sure about that.” I actually think he said we’re still in 2020, maybe post inauguration day, the New Year begins. I thought that was pretty funny. Whichever party you’re in, I’m not in either one, I think it’s a funny way of reflecting on the change in the New Year. I also want to mention that dramatic events happened in Washington, D.C., the city of my birth last week. Last week’s podcast did not attempt to speak to that in any way, because we taped it a day before. I really don’t want to say too much about it now, because it’s not the purpose of Rule Breaker Investing to think too much in that area. So for many people, I’m quite sure the new year will actually begin upon a peaceful transition of power as this happened every century in our nation’s history.

Three down, three to go. Now, often we have a halftime, we bring in our marching band or have a folly ceremony of some sort when I do this podcast, but my producer, Rick Engdahl, points out to me, horse races do not have a half time, so let’s keep moving. Principles No. 4, No. 5 and No. 6, the first three were about building your portfolio. To summarize, make your portfolio reflect your best vision for our future, name its purpose, and will there be money coming in or not, and finally, fair starting line. All three of those, again, about building portfolios, principles for doing it right from day one. But then comes day two and year two, and decade two, and the list goes on. So, for the final three principles for your portfolio, this is about maintaining. I would say even more of the maintaining, which can sometimes sound like a boring word. Like the word maintenance doesn’t have a great connotation for many, how about fostering, growing, overseeing, stewarding? That’s really what these three principles are here to help you do well.

Principle No. 4, establish your sleep number. Now, I realized there could be copyright violations. I hope that the public company whose name is Sleep Number doesn’t come after me for this one. I’m just giving you guys some props here, but establish your sleep number. Now if you have a Sleep Number mattress, I don’t, but many love theirs. You know that you dial a number and it can just be on your side of the bed. Your spouse or partner can have their own number. What’s your sleep number, and the higher your number, the higher the pressure on your side of the bed, the more firm your side of the bed is, and I think it even maxes out. I think it’s 100. That’s what I’m talking about, except in this case, I’m talking about what is the number, your sleep number? What is the highest percentage of allocation in a single stock that you can maintain while still sleeping at night? What is your sleep number? Because as soon as you start to invest in 20 or more companies and let those horses go, they will right away start to find their allocation. One of them will double for you in time, another will lose half its value. They’ll start to settle into their own allocations. You gave them a fair starting line, but starting with day two, it’s no longer even and darn it, I don’t think it should be. So, it’s going to become important for you to know ahead of time, what is your sleep number?

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Let’s take an example. Let’s start with the sleep number of one. Now, I can’t quite imagine what that would be like on a Sleep Number mattress, you are certainly sloshing around. I hope you got some sleep last night, but a sleep number of one for investors in this context means that you are not comfortable having any more than 1% of your money in your biggest holding. That sounds very much like an index fund to me and indeed, most of the world, at least the portion of the world that owns index funds, which is a large portion of the world, has a sleep number of somewhere around one. They’re massively diversified, owning positions in hundreds or thousands of companies, like the Vanguard Total Market Fund. Even if there’s some really big players like Apple and Amazon, trillion-dollar companies that eat up an outsized portion of their allocation, still it’s a very low sleep number. Sleep numbers on index funds approach one in many cases, and that is obviously a perfectly successful way to invest. You are massively diversified.

Now, I’m not speaking to index fund investors, Rule Breaker Investing is talking about stocks. I’m speaking to individual investors like me, mom and pop investors just trying to model through and do a good job in this world, buying good companies that make our portfolio reflect our best vision for our future. If you have a sleep number of one, that means you have a large portfolio. Many Motley Fool members do. My portfolio has about 55 stocks in it, and that includes overseeing a couple of my kids portfolios all taking together 55 stocks or so, some overlap from one portfolio to the next. We have Motley Fool members who have over 200 stocks in their portfolios. In Motley Fool Rule Breakers, at Motley Fool Stock Advisor, if you take all of my active stock recommendations right now combined, you have about a list of 240 stocks. I’m perfectly fine with anybody equally allocating into all of those 240, that would be a sleep number of less than one. But again, the sleep number in this context is what is the maximum number that you or I are comfortable with, with our portfolios’ single highest stock allocation.

I’ll give an opposite example. How about a sleep number of 80, that is a really big number. That is a number that I once rocked and I’ll tell that story in a second. But what we’re saying with that sleep number is that you or I, if we have a sleep number of 80, we’re comfortable with 80% of our money in our largest holding. That means if it gets cut in half overnight, which can happen, I’ve seen it happen, all of a sudden you just lost a lot of money in your entire portfolio because you were so over allocated to a single stock. As I just mentioned, thereby hanging a tail in my early days as an investor, this is even in the first few years of The Motley Fool, as I built out my own portfolio for my kids and my family, I had America Online stock. It was right there in our Fool port, for those who remember the original Motley Fool portfolio that launched on August 4th of 1994. That was my money and I had other money besides in AOL. AOL went on in the next six years to go up 150 times in value. Now if you’re an investor like me, and you say things like, let your winners run and winners win. Even though you started with a fair starting line, if one of those horses charges ahead and races around the track 150 times before many other horses have finished once, you can imagine that you end up with a lot of waiting in that particular stock. For me at its maximum, it was right around 80. I want you to know, I was comfortable with that. It didn’t ultimately end well, AOL ended up declining, especially after the Time Warner merger, but at that point I had reallocated some of it. I donated, given away a lot of it too. It didn’t hurt me as much as you might have thought, and I frankly wouldn’t have let it hurt me much, because I knew my sleep number back then, and I know my sleep number now.

I’m going to mention to you that my sleep number, this might choke you, is probably still right about 80. Now I’m 54 years old. That means I’m closer to retirement than when I was 24 years old, but at the same time, if you saw my portfolio, you’d see my biggest holding is The Motley Fool, my Motley Fool stock. That stock is probably more than 80% of my net worth. I don’t do hard math here, but you can just imagine that I, like many, perhaps many of you, people who co-found their companies and hold onto their stock, that ends up being a huge percentage if the company does well, or their portfolio. That’s why a lot of people, CEOs like Reed Hastings of Netflix or Jeff Bezos, you see them programmatically selling off bits and pieces of their stock in their own company for years and years. That comes from their wealth managers who are saying things like, “Hey, Jeff Bezos, you have over 90% of your net wealth in this one stock. That’s crazy. You shouldn’t have a sleep number that high. We, your wealth managers, would like to suggest you reduce that over time,” which is indeed very rational and generally well-intended and good advice.

All of us are different. My portfolio is different from yours. My situation is different from yours. but I’ve always had the mentality of a double-digits sleep number. I have no problem knowing that the companies that I love could sell off and get cut in half this year. It wouldn’t change much about how I live or how I handle my family. If that’s not true of you, either because A, temperamentally that’s just not you, or B, financially that would set you back too far, you should have a much more normal sleep number. I think for a lot of people, I used to be in an investment club as a younger guy. Anytime a stock became 10% or more of the investment club’s holdings, that was the investment club sleep number. Lots of gentlemen in that club did not like the idea of ever having more than 10% of the club allocated to any one stock. I think I see many of you nodding your heads as you drive your car, bike, or do a run. Listening to this podcast, you probably have come across that kind of mentality. You may well have it yourself. I would say that’s a very fair and rational mentality. Mine is not here to suggest that your sleep number be one or 100. By the way, I don’t think it should ever be 100, really, it shouldn’t be 80. For the vast majority of people, it should be something more like maybe 20. But regardless of what it is, I’m not here to say what your number is. I’m here to say it matters. Establish your sleep number, that’s principle No. 4. Before I go onto principle No. 5, how could I not mention the Gardner-Kretzmann Continuum.

Spontaneously on this show years ago, as my friend David Kretzman joined in and we had a conversation and we realized that it’s not a bad guide for a lot of people to think, what is my age? I should have roughly that number of stocks. If I’m 20-years-old, I should start with the 20 stock portfolio. If I’m 54 years old, oh my gosh, I’m 54 years old. I have about 54 stocks. It’s not bad to keep a ratio of about 1.0. 54 in the numerator, over 54 in the denominator, as your Gardner Kretzman Continuum, your GKC number. Typically, we like that number being one or higher, not a small fraction. I have to pay some slip service here to the Gardner Kretzman Continuum. It’s certainly baked into portfolio Principle No. 4, but I’m calling this with overall establishing your sleep number. Boy, do I hope I’ve made my point clear.

Before I go onto the good news of principle No. 5, the reason we established our sleep number is so that you abide by it, so that if the stock does start to cringe out of control in the best way, that you’re disciplined and you recognize that you might not sleep so well with that amount of allocation and so piecemeal, you can sell that position down to your sleep number. Establish your sleep number, know your sleep number, be awake to the possibility that your sleep number may change over the course of time. I think for a lot of people, as they get older, their sleep number gets smaller and that strikes me as entirely appropriate. Mine here just to push forward the concept to get you thinking about it and acting in your best interest. Principle No. 5, and sure enough it starts with these two words, good news. Principle No. 5, good news, you get to invest through the whole race. Well, principle No. 3, fair starting line, you heard our music at the beginning. I’m going to ask for a little bit more, horsey fun fair once again, because we’re going to stick with this analogy. I’ve always enjoyed it. I’ve rocked it before in this podcast a number of times. I’m really enshrining it now in these principles because I think horse racing is fun and there’s a lot that we can learn from horse racing. But good news, you can kind of cheat as an investor in a way that is better, at the track, never can. If you’re listening to me, and if I make a good case for it here with principle No. 5, you will indeed “cheat with me,” because unlike the betters at the track who have to put all their bets in just before the bell rings and the race starts, no, no, no. You and I as investors, we get to invest through the whole race. A third of the way through, when one of those horses is five lengths ahead of all the others, we can place our bets down right then; with new money that we’re investing, we can look and see who’s doing well, who’s thriving and we can put more and new money toward those we get to invest through the whole race. Now the reason has worked so well for investors and for portfolio builders is because it goes opposite what most people’s instincts are. Most people think buy low, sell high and when a stock in their portfolio drops, they think they should once again, “double down.” Well, if you’re a Rule Breaker investor, you know one of our habits is to add up, not to double down.

We tend to watch what’s happening in the race, the race of business, the race of investing and we get to allocate in a dynamic way, right then. We’re probably buying high and trying not to sell until the very end of the race in a world in which everybody else is trying to buy low and sell high. While there are many ways to beat the market, my favorite and certainly the Rule Breaker way is to pay attention to the six company traits that guide you to the right companies. Then the six investor habits that have you investing properly in those companies, letting your winners run, adding up not doubling down. In fact, principle No. 5 here, good news, you get to invest in the whole race, ties directly back to our other two six point Rule Breaker lists, the ones that have you finding the best companies and the ones that have you acting the best on behalf of your portfolio. For some, they might ask, well, what do you mean to invest through the whole race? How would I do that? My answer is, the company traits and the investor habits answer those questions for you. But the key is you get to invest through the whole race. Now, I realize in particular here I’m speaking to portfolios that have new money coming in. But this point also applies to the portfolios that no longer have new money coming in. The Phoenix portfolio is among us, if you will, you get to invest the whole race, even as you’re a net seller of your own portfolio, you can allocate and should allocate in the way that makes the most sense for what’s working, which companies are thriving.

Often for me, I try to sell off my losers, especially toward the end of each calendar year. I try to sell off my losers and I net out capital gains of my winners to try to reach a zero point, which has me paying no capital gains taxes. I pay a lot of income taxes every year. I always try to pay as little in capital gains taxes as I can. By the way, holding stocks for long periods of time is the best way to do that and really grow your money. But particularly for those who do not have new money coming in, I reached out to Jim Mueller, longtime friend and analysts here at The Motley Fool, who helped manage our Phoenix portfolio. I just wanted a couple of pointers for him before we go to our sixth and final Rule Breaker principle. These are just thoughts that he had for managing a portfolio and I’ve got a few of them. Jim, thank you for these. I’m pleased to share them now with our listener base. Jim said, first of all, the team approach works quite well. I love this point that he makes. I really haven’t spoken to it. I really have been talking to you as a solitary person, a solitary listener, a fellow investor, your portfolio and my portfolio. But because the portfolios we ran through Supernova were team-based and so much of our work is team-based here at The Motley Fool, that’s a great argument for including a spouse, a partner in your considerations or if appropriate your kids or an investment club locally or online. Jim points out different ideas from different people, different perspectives lead to good discussion. Limits, several of the behavioral biases that we can fall into, because we have blind spots and we’re not aware of some aspects of what’s happened in the world, what might be working or not working so that team approach. Jim also said, be slow to sell. Boy, have we ever tried to pound this one home through every way we could at The Motley Fool for years and years now. Jim says really slow, like glacial. If you see problems and if management’s any good, your thesis, by the way, should assume they are. If your portfolio is reflecting our best vision for our future, I sure hope you trust the managers of your companies highly esteem them if possible. If you thought they were any good, then they’re probably seeing those problems too and are hopefully working to correct them.

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Jim gave one example of Panera Bread back when it was a public company in our portfolio. He said we sold half of Panera at about the worst possible time, just as management was turning things around. But before those changes, Panera 2.0 had started showing up in the financials. His point to reemphasize, be slow to sell, really slow, like glacial. A couple more and then we’ll move on to our final principle. He said if you’re lucky enough to have a solid winner, don’t be afraid to milk it for cash. Either invest in other positions or to withdraw for other things. This is a really important point, especially for portfolios that have no new money coming in. Typically you’re doing the opposite of what ISO often council because I talked about winters winning and letting them when. But as we retire and if we have no more money coming in then your greatest sources of capital to live on and also redeploy elsewhere are your big winners.

As your sleep number starts dropping rightfully so in so many cases, you’re going to start diversifying away from those big winners. Jim says, if you’re lucky enough to have one of them, don’t be afraid to milk it for cash. He points out another example you said by selling a bit of Netflix each time it got more than 15% of the portfolio. You’ve just heard the sleep number for our Phoenix portfolio, 15. He said we pulled out way more than we had ever invested in that winner. The position by the way, is still, to this day, quite large. The last point, Jim adds, and again, I’m including all these particularly for those who have portfolios that don’t have new money coming in. I’m going along on that in this point and principle No. 5, he does say a cash balance really can help. They ran the Phoenix mission at essentially a 0% cash position for years. The way we did it, I think the portfolio started with $500,000 of real money. We simulated that once it hit a million dollars, we would go into distribution, mode into no new money coming in mode. That’s the way, that was the game that we built for Phoenix and the people who were playing the game along with us, but with real money in real life.

We said once that $500,000 blooms to $1 million, we’ll call that retirement day. From that point on, we will no longer have any new money coming in and this portfolio will be managed from that million going forward. Well, he’s saying that they were running at a 0% or so cash position right up until that time. They had to sell quite a bit to raise enough cash to then cover the next several years of cash needs for our hypothetical retiree who all of a sudden is now living on this portfolio. We did it by the way, with quarterly withdrawals. Having run it at essentially 0% cash and made it extra stressful for retirement day when we flipped into, “Oh no, I need to sell this thing to live off of it.” Jim says, even without that need, having cash can be really handy when something you want goes, as they sometimes say, on sale. He does feel that under 10% shouldn’t affect overall performance too much. Now, I will say in conclusion on this one, I’m somebody who maintains nearly a zero% cash position at all times. I don’t hold money out of the market thinking, well, I am going to be really opportunistic when the market drops. I’ve often said the opposite. I say things like dip by on dips. I’m not waiting for a dip. There are different schools of thought here, so at least you know mine. But Jim, speaking very rationally well with his own experience to many people, some of my older listeners, who will recognize the benefits of having a cash balance. Finally, portfolio Principle No. 6 for the Rule Breaker portfolio, review your allocations quarterly, manage accordingly.

Maybe the most basic, most repetitive question that I’ve gotten, not just for six years of Rule Breaker Investing email bags, but for years and years before that and I understand why you will ask it is, how many stocks should I have in my portfolio? I’ve done my best to speak to that repetitively over the course of time. I hope I’ve been mostly consistent in what I’ve been saying and the Gardner Kretzmann Continuum was invented in part to assuage those concerns, to have a ready answer to that question. But here, I’m going to have fun and I’m going to say that is the wrong question. You should not ask how many stocks I should have in my portfolio because what I’m saying back is, it’s not about the numbers, it’s about the percentages. Now, an old point that I once wrote an article about years and years ago on fool.com is the percentages not points point. This is basically about how I hate how the market every night is reported, the DOW is up 1000 points or the S&P is up or down or Nasdaq’s up or down points, whatever the number is, because it doesn’t actually give people any context.

Quick quiz, what are 1,000 on the DOW worth in percentage terms these days? Well, if you know the DOW’s around 30,000 and you’re mathematically inclined, that’s about a 3% move. That tells us much more, that something moved by 3%, then that it moved up or down by 1,000 points and then when you get into other indices like the S&P 500 or the Nasdaq, they have their own points and points don’t really help us understand anything. It’s the percentages that provide us the lingua franca and an understanding of how the Nasdaq did maybe versus the DOW or versus your or my portfolio. Percentages, I’ve said in headline material in the past, not points. Well, very similarly, I’m saying that with the number of stocks in your portfolio, percentages not numbers. Whether you have 50 stocks in your portfolio or 150 stocks, what really matters is not the number of stocks, but the allocation percentages toward each stock.

Earlier, I introduced the concept of the sleep number. That is a very important percentage. Let’s think of two quick 50 stock portfolios right now. One of them has 80% of its portfolio in a single-stock, the other has 2% positions in 50 stocks. Both portfolios have 50 stocks. How many stocks, the question goes, should I have in my portfolio? But they are radically different. One is much more risky and much more stressful to manage than the other. So, it’s the wrong question, how many stocks should I have in my portfolio? It’s about the percentages that you have in each one, not the numbers. So again, portfolio principle No. 6, review your allocations quarterly, manage accordingly. Now, the word allocations is all about percentages. It’s all about how much you have in this stock versus that stock and yes, you can look at gross dollars, but I’m encouraging you here of course, to look at the percentages. Jim Mueller mentioned earlier, every time Netflix hit a sleep number of 15 for the Phoenix portfolio, that triggered new activity. That was how that portfolio was managed and that makes a lot of sense given that portfolio to me, it wasn’t about the number of stocks, it was about the allocation, in that case to the biggest holding, Netflix.

Let me give a couple of more frequently asked questions and then use this very principle to speak to them once again. Two more frequently asked questions on mailbags, and I’m hoping by the way side note, that I won’t have to answer these as much in future now that we’re doing these six principles, but a couple of more FAQs run like this. Do I add more to an existing position or should I start a new position? The other one is, how do I sell off stocks to live on this portfolio? So to the first one, I say, well, put every stock at its right allocation. So, your question of whether you should add more to an existing position or start a new position, I would encourage you to look across all your positions and ask, is the percent next to every one of those company names where you think it should be? For example, a new position means you have 0% presently allocated to that potential idea. How much would you like to allocate to it? I would never allocate more than 5% to any initial position, so I hope it’s less than 5%. But would you like that new promising stock to be a 1.5% position in your portfolio, maybe as a sort of a starter position for your portfolio or is there this wonderful company that you think is very promising that just sits there at a poultry 0.8% of your portfolio? In other words, you have less than 1% of all your money in this portfolio in that stock, maybe you should add to that one if it feels like it should be at 1.5%. Similarly, when thinking about selling off stocks, the question is, well, which one should I sell? Well, I spoke to that a little bit earlier, but I would say in keeping with principle No. 6, sell every stock down to its right allocation, whatever you think the right allocation is. So in a world that so often is looking at numbers and not percentages, I feel as if we’re often guilty of doing the same when we talk about our portfolio, you really should have the percent view on your brokerage statement page or your fool.com watch list, you should be looking at the percentages that you are allocating each of your stocks.

By the way, to close and to return this principle, review your allocations quarterly, not daily, not weekly, not even monthly. I mean, I guess you could if you want, but I don’t think it’s worth spending too much time this way. I think four times a year is a great time to spend a little time, put an appointment in your calendar, maybe it’s on a Saturday afternoon. You could’ve been repairing the gutter that afternoon, but you decide, make sure quarterly you’re going to look back at your allocations and reallocate as necessary, manage accordingly, check-in about quarterly. All right, to now summarize those three principles No. 4, No. 5 and No. 6 for maintaining, for stewarding your portfolio No. 4, establish your sleep number. No. 5, good news, you get to invest through the whole race and No. 6, review your allocations quarterly, manage accordingly. Here I would say once again, percentages, not points or numbers. Of all my podcasts in 2021, I think this will be one of the few that I will still be recommending in 2022 and 2032, because I’m trying to lay down some timeless principles that give you a framework that you can put into play in your own life and invest better. I will end as I began, this is a draft. Does this help? Am I missing anything big? Would you like to tweak my language or suggest I add or subtract anything? I would love to hear back from you in this month’s mailbag, which comes up in two weeks. Of course, our email address, rbi@fool.com. Again, thank you in advance for your best thoughts. Yep, rubbing my hands together for next week, five stocks sampler. I already know my theme, it’s going to be fun and reviewing two past five stock samplers, probably with an analyst friend or two. In the meantime, have a great week, stay safe, wash your dang hands. Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.


View more information: https://www.fool.com/investing/2021/01/23/the-6-principles-of-a-rule-breaker-portfolio/

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