An attempt to come up with the optimal allocation strategy↓
The age old question of exactly how many stocks to hold is likely never going to be definitively answered. There are entire books, even courses, on the subject after all.
Since portfolio construction is more of an art than a science, in this post I want to break down relevant studies, examine historical data, and analyze some of the best investors in an attempt to come up with the optimal allocation strategy. As always, please share your comments and thoughts below!
“Wide diversification is only required when investors do not understand what they are doing.” — Warren Buffett
My investing strategy, which is definitely not perfect, consists of holding relatively few stocks (around 10 or so). This is because I want to invest in wonderful companies purchased at attractive prices. I have found that these opportunities, especially of late, don't seem to come around all that frequently. This also makes me a big believer in holding a decent amount of cash in my portfolio as well. But why adopt this strategy?
It's simple logic the more stocks you own, or the more diversified you are, the less likely you are to underperform the market. By this same logic however, you're also much less likely to outperform the market. Say you own 2 stocks and one doubles while the other stays flat. You still earn a 50% return. With 4 stocks and one doubling - a 25% return. What about more? Say you own 10 stocks and one doubles while the others go nowhere. You'd still earn 10%. 20 stocks... 5%. 100 stocks... 1%. While this may be an oversimplified example, you get the point. The more stocks you own the more your results trend toward average.
But let's look as some more numbers. In the book Investment Analysis and Portfolio Management, Frank Reilly reviewed studies regarding randomly selected stocks and found that as little as 12 stocks could attain around 90% of the maximum benefits of diversification. He also goes on to note if the individual investor is properly diversified, 18 or more stocks = full diversification according to his research, then the investor will average market performance. According to Mr. Reilly the only way to beat the market is by being less than fully diversified.
In his book, You Can be a Stock Market Genius, Joel Greenblatt came to a similar conclusion. Greenblatt found statistics that showed owning only 2 stocks can eliminate 46% of non-market risk. This number climbs to 72% with 4 stocks, 81% with 5 stocks, and 93% with a 16-stock portfolio. As you can see, the amount of non-market risk can be decreased with the more stocks you own. Which was already obvious. But let's keep going. You would need to own 32 stocks to eliminate 96% of non-market risk and a whopping 500 stocks to almost eradicate it (99%). Greenblatt's point is there seems to be a pattern of diminishing returns after a certain number of stocks. Personally, I would argue maximum benefit is to be had between 8-16 stocks.
“We believe that almost all really good investment records will involve relatively little diversification. The basic idea that it was hard to find good investments and that you wanted to be in good investments, and therefore, you’d just find a few of them that you knew a lot about and concentrate on those seemed to me such an obviously good idea. And indeed, it’s proven to be an obviously good idea. Yet 98% of the investing world doesn’t follow it. That’s been good for us.” — Charlie Munger
So we've seen the more stocks you hold, the less chance you have of underperforming the market. This also means the less chance you have of outperforming the market as well. By this logic, the only way to increase our chances of success, is to hold less stocks than a completely diversified portfolio. By doing this we take on the inherent risk of owning stocks, so the real question to ask yourself is why are you investing in individual stocks?
“If you want to have a better performance than the crowd, you must do things differently from the crowd.” — John Templeton
If your answer is to invest your money in a proven vehicle that, historically speaking, beats all other investment options... and you don't want to take the time and effort to perform proper fundamental analysis on each and everyone of your stocks, then I would recommend an index fund. I mean let's face it, we're not all Warren Buffett or Peter Lynch and we're likely not going to be. But there is still no situation I would ever recommend going out and buying 50 some odd stocks just to say you're diversified. As we just talked about, this can actually increase risk and reduce your chances of success in a variety of ways. Index funds, on the other hand, are a great way to expose yourself to the stock market and are likely to beat every fund manager over the long haul anyway.
Now, if you're answer is you think you can beat the market, then I recommend you keeping a fairly concentrated portfolio of 8-12 stocks. Why 8-12? Well for one you don't want to be too diversified for all the reasons stated above. And secondly, we've seen you can only diversify so much before the benefits begin to severely drop off. Lastly, if you're really practicing a true value investing strategy, it's unlikely you're going to find an abundance of opportunities out there. To mitigate risk, search out high-quality companies with a competitive advantage, and purchase when they're selling at a discount to their intrinsic value. By concentrating your portfolio, you can obtain a thorough understanding of each company, and coupled with a value investing strategy, decrease risk while increasing returns.