This is probably something that has been argued for the longest time ever – but how many stocks should an investor own?
Should one have a diversified or concentrated portfolio?
This data comes from a famous value investor, Joel Greenblatt’s book, You Can Be A Stock Market Genius. According to Joel Greenblatt’s book, the risk-reduction benefits of adding more stocks to your portfolio significantly decreases once you get to about 20 or so stocks. Whitney Tilson too citing the data, said that “owning two stocks eliminates 46% of non-market risk of just owning one stock.” As you add stocks to the portfolio, that non-market risk declines as such:
• Owning 4 stocks eliminates 72% of the non-market risk
• Owning 8 stocks eliminates 81% of the non-market risk
• Owning 16 stocks eliminates 93% of the non-market risk
• Owning 32 stocks eliminates 96% of the non-market risk
• Owning 500 stocks eliminates 99% of the non-market risk
What is Market vs. Non-Market Risk?
Market risk is the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. Market risk, also known as “systematic risk,” cannot be eliminated through diversification. Some examples of market risk are like recessions, political tension, natural disasters, terrorist attacks etc. Market risk affects the entire market at the same time.
Non-Market Risk on the flip side are when investors experiences losses due to factors specific to the company itself. Such as when a company announces news of profit warnings or something even worst like corruption or fraud. This is termed as non-market risk, otherwise also known as ‘unsystematic risk’. Such risk can be eliminated through diversification and the percentage of removal can be seen above.
So while diversification has its benefits of eliminating non-market risk, is there a case to be made for having a concentrated portfolio?
Let’s assume you want to achieve 15% returns a year:
Example 1: Assume you want to hold 20 stocks, each equally weighted at 5%, 15% return can be achieved by:
- 5 of the stocks growing 60% in share price and the rest breaking even
- 10 of the stocks growing 30% in share price and the rest breaking even
Example 2: Assume you want to hold 15 stocks, each equally weighted at approximately 6.7%, 15% return can be achieved by:
- 5 of the stocks growing 45% in share price and the rest breaking even
- 10 of the stocks growing 22.5% in share price and the rest breaking even
Example 3: Assume you want to hold 10 stocks, each equally weighted at 10%, 15% return can be achieved by:
- 5 of the stocks growing 30% in share price and the rest breaking even
- All of the stocks growing 15% in share price and the rest breaking even
From this, one can see that the lesser the number of stocks you are holding, the lesser you require in terms of stock performance to reach your targeted portfolio performance goal. The key here will be that you would require a high amount of conviction when running such a portfolio. Furthermore, if one were to analyse history, many concentrated investors have blown up as well.
However, how would we know if our conviction is well placed? Look at Bill Ackman, he definitely showed huge amounts of conviction in terms of his Valeant bet, but it did not stop the stock from tanking, bringing down his entire portfolio.
Ultimately, there can be arguments made for having a diversified or concentrated portfolio and bother are equally logical to me. While I have nothing against running a concentrated portfolio, and have friends who have done extremely well doing so, I still prefer running a diversified portfolio.
It is always about that fat tail risk, on the off chance you are wrong and that is something which is probable no matter how intelligent or hardworking you are. Even if it is a 0.01% probability event, would you want to risk taking that chance?
As to how many stocks to hold within a diversified portfolio – 8 stocks, 16 stocks, 32 stocks or even 500 stocks, it really is up to every individual. Personally, I find 20 – 30 stocks being the sweet spot, where it is enough to eliminate most of the non-market risk but at the same time being able to still understand what companies you are investing in. After all, investing is taking a part ownership in a business. Hence, investing in 500 over companies makes absolutely no sense to me as how well can we really understand all 500 companies!
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