How Many Stocks Should Be In My Portfolio?

how many stocks make a diversified portfolio

Summary

  • Many value investors recommend a concentrated portfolio.
  • Concentrated portfolios can and do subject investors to significant losses.
  • Most academic studies recommend anywhere from 20 to 100 holdings.
  • Portfolio size should depend on investment strategy.

How many stocks should you hold in your portfolio? It's one of the age old investment management questions.

Many famous investors, particularly value investors, advocate holding only a small number of stocks in your portfolio. They say when you find a compelling investment you should make a big bet. Indeed, famous investors like Warren Buffett, Bill Ackman, and David Einhorn tend to run very concentrated investment portfolios with perhaps a dozen positions at the most. They also point to their success at generating above market returns as validation of having a concentrated investment portfolio. But is it really that simple?

I don't think so. The problem is that these examples ignore the converse, what about investors who ran concentrated portfolios and lost substantial amounts of money? You rarely hear about them. The media tends to ignore these examples unless the fund's blow up is particularly destructive such as Long Term Capital Management nearly taking down the entire financial system in 1998. Most investors rarely hear about these poor performing funds because the managers usually fade into obscurity.

You mostly end up only learning about them if you happen to know them personally. In fact, I know of one situation where a concentrated portfolio led to the collapse of a fund. Since I consider the manager a friend, I don't want to name them or give too many details. This person was Ivy League educated and studied under and worked for a very famous value investor. They were smart and hard working and had their client's best interests at heart but an overly concentrated portfolio with a few investments that went against them led large losses during the recent bull market and to the eventual closure of the fund.

There are also a few famous public examples such as Bruce Berkowitz' Fairholme Fund (MUTF:FAIRX ) that made concentrated bets on the financial sector and Ken Heebner's CGM Focus Fund (MUTF:CGMFX ) that made a variety of concentrated investments that have led to these funds to underperform the broader stock market over the past five years and in Heebner's case the past decade.

Academic research also supports the view that running a concentrated portfolio is not ideal. In 1968 the first study was done on how many stocks you need to hold to diversify away individual company risk. In the intervening decades the investment and academic community has continued to churn out new studies attempting to pinpoint the ideal number of stocks for a portfolio. In almost all cases the studies used volatility as a proxy for risk and many dealt with just the US stock market. Most studies have found that a portfolio of 20 to 30 stocks will diversify away 80% to 90% of individual company risk (again, technically volatility). If you are investing in international stocks as well, and you should (you'll find out why later), you may want to increase the number of holdings.

On the flip side, investors also run the risk of holding too many stocks in their portfolio. The more stocks an investor owns the higher the transactions costs for the portfolio and the more time it will take to properly manage and keep track of the progress of each holding. If your goal is to outperform the market, the more stocks you hold the closer your portfolio will be to matching the market. If dividend investing and current income is your goal, buying more stocks with lower dividend yields solely for diversification will reduce your dividend income. So, just as there are risks with holding too few stocks, there are risks with holding too many.

Diversification Means You Need to Think Global

It's

also important to remember that diversification includes not just companies in different lines of business but also in different countries as well. One thing that US investors chronically overlook is adequate global exposure. The United States makes up only about half of the world stock market! Investors who limit their holdings to just the US are ignoring half of the market.

While I wouldn't recommend diving headlong into the Argentinean stock market I would recommend investing in large companies trading in developed market such as Canada, Western Europe, and Japan. These companies follow International Financial Reporting Standards (IFRS) and more importantly to American investors, publish reports and investor relations materials in English. Additionally, many trade on American stock exchanges through ADRs (American Depository Receipts). Also, remember that global exposure does not necessarily mean foreign companies. For example, some quintessential American companies have significant global operations such as Coca-Cola (NYSE:KO ) which derives 53.3% of its sales outside of North America or McDonald's (NYSE:MCD ) which gets 68.5% of sales from outside of the US.

The "Pigs at a Trough" Method

We use, and recommend, an approach I like to call the "pigs at a trough" method named after Foster Friess' approach to selling stocks when he ran the Brandywine Fund. You can imagine your portfolio as a feeding trough with space for a finite amount of pigs (investments). This strict rule helps investors accomplish two things.

First, it forces you to remain diversified since you need to keep each space filled. It prevents you from believing too much in your own genius and devoting too much money to one investment idea. Instead you are forced to come up with a reasonably diversified portfolio by virtue of having a number of spots at your trough to fill.

Second, it helps you to limit your portfolio to just your best ideas. With only a finite amount of spots available you must think carefully about whether or not to sell a stock to add a new idea. It prevents you from being tempted by the latest investment fad or a hot IPO as you must carefully consider whether the new investment will be better than any of your older investments. This buying and selling discipline also helps to limit turnover and studies have shown that portfolios with lower turnover rates tend to outperform those with higher turnover.

So, how large should your investment "trough" be? How many stocks you should have in your portfolio also depends on your investing style. If you are building a portfolio of dividend stocks for retirement income or following a dividend growth strategy then a portfolio on the lower end of the academic studies, about 20 to 30 diversified stocks, should be sufficient. Dividend paying stocks tend to be larger, more mature companies with reliable revenue streams as well as being less volatile then the market. On the other hand if you are following a low P/E or low price to book strategy which tends to be more volatile and lead to investments in more speculative companies, especially a low price to book strategy, then a portfolio closer to the upper range of the studies such as 30 to 50 stocks might be more appropriate. Even riskier investment strategies such as looking for stocks trading below net working capital, startups, investment stage biotechs, etc might need portfolios approaching 100 stocks in order to reduce individual company risk to acceptable levels.

Over the long term stocks have averaged around 9% to 11% annual return (depending on the time periods and market indices). In order to insure that your portfolio performs at least as well as the market you should keep in mind how the market is weighted.

The following tables show the sector weightings for the S&P 500 and global stock market as well as the country weighting for the global stock market.

Table 1: S&P 500 Sector Weightings [1]

Source: m.seekingalpha.com

Category: Forex

Similar articles: