One of the questions that every private investor faces sooner or later is to decide how many stocks should you hold in your portfolio. How much diversification is enough?
Go wide?
There’s lots of advice on this from index fund-ees who say you should own the whole market (and maybe a bond fund, or international market too) in order to be truly diversified and protect yourself from the risk of any particular situation. That works well if you want to take a passive and hands-off approach.
To be honest, it’s not a bad strategy – aim to match the market (minus some small management costs of an index fund) and stay committed through thick and thin.
There’s also advice from mutual fund leaders who say private investors should own at least a few hundred stocks, so better buy their fund since diversification is the only free lunch in stock investing.
And then you get to the other end of the spectrum – for folks that are willing to take an active role in managing their own stock portfolio. This is no small thing as it requires ongoing and dedicated effort. Ironically, if you only put in a small amount of energy, chances are the index returns will be your performance ceiling rather than floor to any tweaking you may do.
Business-like Investing
What if you treated your stock investing like a business? That’s an interesting analogy: If you ran a business where you were in day-to-day control, and without you nothing happened, how much time and effort would you dedicate?
What if you ran a burger stall, a shop, a software house or a newspaper? How long would it last if you spent just a few hours a week at work? Of course, it would flop (assuming you haven’t already grown your empire to a stage where you manage it from a balance sheet with a capable management team – even they require leadership).
Why should your stock portfolio be any different?
Masters have focus
Joel Greenblatt (Trades, Portfolio) has a really interesting way of looking at it from a business owner’s point of view. In his book, “You Can Be A Stock Market Genius” he describes how once you’ve created some wealth from one business, buying into a handful of local, well-run businesses that you can understand would be considered prudent.
Maybe a local entrepreneur buys holdings in 3-4 companies, giving a portfolio of 4-5. (By local, this could mean geographically, or by expertise).
Why not be the same with a stock portfolio? Buy a small handful of businesses you understand and get to know well; then watch them. Most advisers would suggest a stock portfolio with just 5 companies would be extremely risky – true if you don’t know them well.
For a well researched stock portfolio, Greenblatt says you get 80% of the benefits of diversification with just eight stocks. He suggests a portfolio of 8-12 stocks for active private investors.
Buffett’s 20-punch card approach
Consider Warren Buffett (Trades, Portfolio), who early in his investing career, invested over half of the partnership’s assets in a single stock, GEICO, when he thought there was compelling value. It also contributed to his early partnership’s ~50% returns.
Taking it one step further, Buffett is well known for his 20-punch hole analogy when talking to business students on an investment philosophy:
“I always tell the students in business school they’d be better off when they got out of business school to have a punch card with 20 punches on it. And every time they made an investment decision they used up one of those punches because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five, or three, or seven and you can get rich off five, or three, or seven. But what you can’t get rich doing is trying to get one every day.” Warren Buffett (Trades, Portfolio), 1991
It doesn’t necessarily mean Buffett advocates just 20 positions in an investing lifetime – it’s impossible to know in advance which will play out long-term. But it is a powerful way to get your thinking aligned with long-term investing. This is also consistent with Buffett’s behaviour more broadly on the power of insane focus.
Probably the single biggest lesson I’ve learnt in my investment journey so far has been the value of focus. It’s actually quite hard to do in practice, but awareness of it (and writing about it on this blog) serves as a useful reminder.
Lynch’s advice for hunting ten-baggers
Peter Lynch, master investor of Fidelity’s Magellan fund had a superficially different take: he owned hundreds of stocks for his fund – sometimes over 1,000! Yet he still managed to garner 29% compounded returns over his stewardship of Magellan from 1977 to 1990. What gives?
1. Lynch grew Magellan from under $20 million to over $13 billion in assets under management, so moving the needle became much harder, forcing diversification. As a private investor, you have the luxury of choice, liquidity and no declared investment memorandum dictating certain behaviors.
2. Many of his positions were very small – these were early stake-holdings as a way to be on his radar. Meaningful positions were usually much larger.
3. Speaking of analysts – he had a whole team at his disposal. This means they had bandwidth to cover a large number of stocks, and it was their full-time jobs. As a private investor, you HAVE to focus to stand any chance to outperform.
4. Lynch also felt that predicting ten-baggers in advance was a fool’s game. While he defined certain characteristics they seem to have, he was the first to say this is no guarantee. Rather, you play your best game, watch closely, and over time the handful of ten-baggers reveal themselves. Despite his track record, he humbly admits it was a numbers game: turning over a lot of stones was one way to reveal the diamonds in the rough.
His advice to private investors was simple: Own enough situations that you may discover some ten-baggers – Over decades, even two or three such situations can make an investing career.
But don’t own so many that you can’t watch your holdings closely enough (watching business developments, not hyperactive price monitoring). He suggested somewhere between 10 to 20 stocks in a portfolio would fit the bill.
What can you manage?
In the end, it does come down to personal preference. Based on the master's advice, I would suggest somewhere between 8 and 20 stocks for an active portfolio. My portfolio tends to be 10-12 positions; I’m also happy to hold cash while awaiting suitable situations.
How many stocks do you have in your portfolio?
Raman Minhas writes about investing using Growth At Reasonable Price to find interesting and profitable opportunities. If you enjoyed this article, join his free newsletter.
