Investment Strategy

How many different stocks should you own? (Part II of II)

In the last OfWealth Briefing I started looking at the important question of how many different stocks you should own, with a view to keeping risks under control. I said I usually recommend at least 20 and up to 30, but with fewer in some circumstances. Today I’ll explain why.

Sensible diversification is essential for any investor. But, at the same time, diversification just for the sake of it is a bad idea. As is just sitting on too much cash, for too long, in the incorrect belief that it’s “low risk”. Part I gives more detail on those points.

Now I’ll focus on how many stocks to hold in the stock part of your portfolio. What risks need to be kept in check? How do you mitigate risk in an easy way?

At the nub of this matter, it’s all about finding the right balance between managing risks while keeping things manageable.

To understand what I mean by that, first of all, I’d better be clear what I mean by “risk” and “manageable”.

What “risk” should you really worry about?

Most of the financial literature defines risk in terms of exposure to adverse price swings. This is understandable, given that a great many institutional investors and other market professionals get into trouble if their portfolios fall too far, measured at market prices.

For example, investment banks and many hedge funds are highly leveraged, meaning they fund their assets with a lot of debt. If asset prices collapse, then they quickly become insolvent.

Banks and insurance companies have to ensure minimum capital reserves, set by government regulators. So they’re similarly averse to big price swings in their assets – lest they have to raise new equity and dilute their shareholders (including management).

Corporate pension funds can’t risk big funding deficits, otherwise the sponsoring companies have to stump up a lot of extra cash to plug the hole. That’s never a good look.

But private investors – at least those with a long term horizon and a lack of leverage (the only kind of investing that I encourage) – should look at things differently. Short term price swings are a source of opportunity, and not risk.

After all, if something is worth $100, would you prefer to pay full price or buy it at a big discount for $60? I think it’s pretty obvious. Whether it’s socks or stocks, it’s best to buy them when they’re on sale.

Let’s say you own a selection of attractively priced stocks in financially sound companies. If there’s a stock market crash, which drags everything down indiscriminately, what should you do?

Assuming the companies remain sound – which is to say their assets are unimpaired and their long term earnings potential is unchanged – I’d argue you should buy more at a lower price.

(A topic for another day, but here I’ll simply note that most of the value of stocks relates to earnings that will be generated many years from now. Therefore, market short-termism – such as the obsession with blips in reported quarterly earnings – regularly offers up great opportunities for those blessed with a little patience.)

Short term price drops, of the kind caused by general market moves, are irrelevant to the underlying value of a company and its stock. Instead, these situations just offer a better entry price for the best assets.

So, if short term price swings are not the real risk for private investors, then what is?

The real risk is a genuine change of circumstances that impairs a stock’s underlying value (being distinct from its current market price).

This could be caused by things like new competition, poor strategy, a hike in taxes, government regulations, insider fraud and such like. Circumstances can change, and that’s the real risk for the patient private investor in (reasonably priced) stocks.

(It’s worth noting that circumstances can also change for the better. Upside surprises are common too. For example, big corporate tax cuts are great for exporters, giving them an improved position relative to foreign competition.)

That said, and as I indicated before, academic work on the issue of how many stocks are enough almost always focuses on the “risk” of random price swings. In financial jargon, it separates “systematic risk” from “unsystematic risk”.

Put simply, systematic risk is the risk of the whole market “system”, with maximum diversification achieved by owning all stocks available.

For its part, unsystematic risk is the additional risk of an individual company or industry. The more stocks are owned, the less the unsystematic, company-specific risk, becomes, as it’s diversified away.

The academic studies focus on how many stocks are needed to eliminate most of the unsystematic part. That leaves the investor with just the systematic, or market, risk to worry about. At least in theory.

Back in 1970, Lawrence Fisher and James H. Lorie concluded that 32 stocks were enough to achieve 95% of the diversification benefit of the stock market as a whole (in the USA). Later work by Sur and Price concluded that 60 stocks, or almost twice as many, were needed to get 86% of the diversification benefit.

Of course, these studies are specific to one individual stock index. If the index itself is already walking on the wild side – perhaps due to a volatile political environment (Venezuela, anyone?) – getting rid of most of the individual stock risk will still leave plenty to worry about. (For the avoidance of doubt, I’m using the mainstream definition of risk here, being exposure to short term price swings.)

Managing the right risks

The flip side to keeping risks under control is keeping the portfolio manageable.

No one wants to track dozens or hundreds of individual positions, let alone thousands. At some point, the theoretical reduction of risk from extra diversification is offset by the sheer unwieldiness of having too much to watch. There’s only so much you can juggle.

Ultimately, it comes down to personal preference. By that I mean how much time you want to spend on it. That’s time spent finding attractive stocks in the first place, investing in them, and then keeping a watchful eye on them.

But the distribution of your overall stock portfolio matters too. By which I mean, whether you’re solely invested in individual company stocks, or whether you blend them with index or sector funds (mutual funds or ETFs).

First, let’s consider a stock portfolio that’s purely made up of individual stocks.

Ask yourself this question: If one company unexpectedly hit the wall, how much would you be prepared to lose from your investment in it?

Personally, under normal circumstances, I think this should be in the range of 2% to 3% of all your financial investments. In exceptional cases – for example concerning a stock that you’re especially comfortable with, that’s still reasonably priced, and perhaps that has already made you big gains since purchase of a smaller position – this could be stretched to 5%. But the norm should be in the 2% to 3% range.

In reality, few stocks – even distressed ones – turn out to be total, or near total, losses. So a 2% investment is really more like a 1% risk. But total or near total loss can happen.

Just think of all the bank stocks that were decimated between 2007 and 2009, losing 80% or 90% for investors (or more, in some cases).

A more recent example is Carillion plc. Until recently it was the UK’s second largest construction company, and had huge government contracts to build hospitals and the like. In 2014 the stock reached 379.4 pence. A couple of weeks ago it was suspended from trading at 14.2 pence, down 96%. The company is now going through insolvency.

How many stocks you need

If 2% to 3% is a good guideline for normal exposure to individual stocks, how many are needed overall?

Right now, as regular readers know, I recommend a 40% total exposure to stocks. Divide 40% by 3% and you’d need 13 or 14 stocks. Divide by 2% and you’d need 20.

At 60% total stock allocation these figures rise to 20 and 30. At 80% allocation – which would be totally sensible in the aftermath of a big market crash, having picked up loads of the plentiful bargains on offer – we’d get to 26 and 40. That said, after a crash the risks are much lower – due to the more favourable pricing – so bigger starting positions of, say, 4% would be acceptable in some cases.

Overall, my general recommendation is to aim for 20 to 30 individual stocks, again assuming no positions in funds, which are already diversified. But, in the end, it will come down to your personal preferences regarding risk and how much time you want to spend tracking your portfolio.

Of course, however many stocks you own, it’s essential that they’re well diversified between themselves. They can’t just be clones of each other, competing in the same or very similar businesses.

You need to spread your stakes by industry and geography (either where they’re headquartered or the geographical mix of where they do business), and preferably by market capitalisation (small, mid, large and mega caps).

(This is a golden rule at OfWealth Stock Investor, where I’m currently building out a diversified portfolio of carefully screened, recommended stocks for members.)

The point is that owning 10 stocks from the same sector (or country) won’t give you the same diversification benefits as owning one stock in each of 10 different sectors (or countries).

Apart from owning 20-30 of the best individual stocks, to maximise the profits but keep the risks acceptable, there’s the alternative of using mutual funds or ETFs, or a blend of stocks and funds.

For example, you could build a portfolio of 5-10 country or regional ETFs – bought when they’re attractively priced, of course. This will give you an instant portfolio of hundreds – probably thousands – of individual stocks.

Taking that route, profits are unlikely to be as high as a well-selected portfolio of individual stocks. You’re unlikely to beat the markets you’re in. Although, if you invest internationally, you might beat the home market you’re from.

Plus there are management fees to pay, and trading costs from the constant portfolio churn of big, diversified funds. But you can still do quite well, if you buy well in the first place.

Also, many people have a strong home country bias. So a third alternative would be to own your home country index ETF (or a few of them from different providers). That will give you anything from dozens to thousands of underlying stocks, depending on the country. Then you can complement it with some individual stocks, many from elsewhere in the world (for geographical diversification).

In this case, something like 10 to 15 stocks should do the trick. That would leave you with about 11 to 20 positions overall, depending on how many funds are also included.

There’s no right answer to how many stocks to own. In the end it comes down to personal preference, and what else is in your portfolio. My own recommendation is that most people should build up to 20 to 30 individual stocks. But fewer is okay, if you own a range of stock funds as well.

Whatever number is right for you, I do recommend you include at least some individual stocks, since that’s where the greatest profit potential lies.

Just make sure that they’re carefully selected, and bought well – by which I mean, acquired at an attractive price in relation to their income and growth prospects (see here).

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

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