What is The Perfect Number of Stocks to Have in Your Portfolio?
When it comes to stock investing, there are two broad approaches/strategies: passive investing and active investing.
The active strategy is where you actively buy, sell and manage individual stocks in hopes of producing market-beating returns with your investment portfolio.
A common question posed by many active investors is this: How many stocks should I have in my investment portfolio?
Truth be told there is no one size fit all answer.
Instead, the answer to this question about the ideal portfolio size is dependent on your investment knowledge and expertise, appetite for risk, and the amount of time you are willing to invest to research great stocks for your portfolio.
Let’s take a look at it now.
Active Investing: Invest in a Handful of Wonderful Companies
Before we look into the research, it is important for you to know what you are getting into when engaging in active investing.
This investment strategy can work wonders if you have a vast knowledge and deep understanding of stocks, know how to interpret a company’s financials and have a good grasp of techniques to value stocks.
You will also need to keep up with a company’s quarterly and annual reports to keep track of the company’s financials and commit at least six to eight hours weekly to analyse companies to add to your portfolio.
Another thing you will have to factor in is your investing costs. This strategy will incur more transaction costs than passive investing as you will have to buy multiple stocks instead of one ETF or mutual fund.
How Many Stocks to Own in Your Portfolio
There is no magic formula to the number of stocks you should have in your portfolio.
But as a general rule of thumb, the majority of investors both professional and retail have about 12 to 20 stocks in their portfolios.
There is a method to this madness as owning this amount of stocks greatly reduces unsystematic risk, which is defined as the risk that is inherent in a specific company, industry and the company’s geographical location.
By investing in a range of companies and industries spread across geographical locations, you can significantly reduce unsystematic risk through diversification.
P.S. Here is a quick guide to diversifying your investment portfolio.
Let’s see what the experts have to say about this.
In the book Investment Analysis and Portfolio Management, authors Frank Reily and Keith Brown conducted a set of studies of randomly selected stocks and found that:
“…about 90 per cent of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.“
To put it in another way, you get to enjoy about 90 per cent of benefits brought about by diversification, by having about 12 to 18 stocks in an equally weighted portfolio diversified over sectors, industries and geographical locations.
But you will also have to take note of concentration risk.
For example, you could have an investment portfolio with stocks from a select few industries instead of one that is diversified over multiple sectors. This example shows that you can have numerous stocks and still not have a diversified portfolio.
Similarly, the author of A Random Walk Down Wall Street, Burton Malkiel supports this idea:
By the time the portfolio contains close to 20 [similarly weighted] and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.
As such, what the experts are saying is this.
Although investors will have to accept a greater systematic risk when investing in a specific company or industry for a chance at higher returns, they should not bear unsystematic risk no corresponding increase in return potential after a certain number of stocks.
But it is important to note that there is a very real risk to over diversifying when it comes to stock picking as well.
In the event that you own two many stocks in your portfolio, it becomes extremely difficult and time-consuming to really know the companies you are investing in and keeping track of them.
As such, the competitive insight that you have about these stocks is diluted, as having too many stocks increases the risk of you missing certain details when you inevitably have to divert your focus.
Also, as you move out of your circle of competence by owning more stocks, you might also weaken the competitive advantage you might have had as an investor.
Thus, you will need to take the time to evaluate yourself to recognise your limits and the amount of time you are willing to spend analysing stocks.
One of the most important tenets of investing is maintaining the balancing act between risk and reward.
Generally, active investing is riskier than passive investing.
Although a more concentrated portfolio can give you a better chance of higher returns, it comes with its risk too.
Let’s say you were to construct a portfolio where your top holding constitutes a big position (e.g. >20 per cent) in one stock.
And since you did your due diligence, the stock turned out to be a multi-bagger (stock that delivers more than 100% return on your investment).
Your returns will be clearly better than if you have a more diversified portfolio of many stocks with poorer returns.
This, however, is a double-edged sword as having a concentrated portfolio can also amplify your loses.
The same big position in your concentrated portfolio might just turn sour (think a case of fraud like Wirecard) and have a large negative impact on your portfolio returns and capital invested.
Another thing to keep in mind is that these theories are based on previous historical data. And because past performance is not indicative of future returns, the stock market might not produce the same outcomes as it did it the past.
Simply put, there’s no one-size-fits-all perfect number of stocks to have in your portfolio. The right number of stocks can be wonderful for one investor and just awful for the other.
Although the number you see here is a good guideline.
But, you will still need to take stock of your investment knowledge and expertise, risk tolerance, and the amount of time you are willing to invest to research great stocks for your portfolio and proceed accordingly.
All the best!
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock. The writer may have a vested interest in the companies mentioned.