How Many Stocks Should You Own?
Investors looking to 'concentrate' would be wise to look at two investing legends -- Warren Buffett and William J. O'Neil.
You've reached your free article limit
You've read 0 of 1 free Pro articles.
Traders that produce exceptional returns tend to have one thing in common -- they bet big on their best ideas. If you hold bigger and more concentrated positions in the best stocks, then you will generate much higher returns than if you hold a diversified portfolio that will inevitably contain some stocks with mediocre results.
The problem is risk. Broad diversification reduces risk, while a concentrated portfolio of promising stocks will greatly increase it. Diversification protects you from making big, costly mistakes, but it also limits your profits when you have a great idea.
The conventional investment wisdom is that a diversified portfolio should hold 25 to 30 stocks. This is concentrated enough so that good stock selection will produce positive results and allow for outperforming the indexes but not so concentrated to produce risk that one bad stock will destroy investment returns.
Many, if not most investors are happy if they can beat the return of the indexes by a few percentage points. The best way to do that is to be diversified enough so that returns are correlated with the indexes and have some potential upside from good stock selection.
However, investors who want to substantially outperform the indexes almost always have more concentrated portfolios. They go big on their best ideas.
The best example of this is Warren Buffett. Buffett is considered to be a very conservative investor, but the concentration in his portfolio is extreme, and there are very few investment advisors who would recommend following his example.
Buffett holds around 50 positions in his holding company, Berkshire Hathaway BRK.ABRK.B , but 71% of his holdings are in just four stocks: Apple AAPL , Bank of America BAC , American Express AXP , and Coca-Cola KO .
For the average investor, it would be extremely risky to have 70% of their cash invested in just four stocks, but Buffett manages this risk by focusing on fundamental value and by holding for very long time periods. His stock selection is unlike the average investor who buys less-established companies and typically looks for faster returns. Buffett is far more concerned about safety than short-term performance, which allows him to maintain a very concentrated portfolio.
Another example of using a concentrated portfolio comes from William J. O'Neil, the founder of Investors Business Daily. O'Neil suggested that accounts up to $200,000 hold just four or five stocks and stated that "those who have more than a million dollars to invest should limit themselves to six or seven stocks."
O'Neil discussed dealing with the risk of this concentration in two ways. The first is with very careful stock selection. Every stock must meet its checklist for earnings and revenue growth, relative strength, and other factors. In addition, manage concentration risk with very rigid money management. Losses are cut at 8%, and there are clearly defined rules for taking profits and cutting losers.
The problem that most investors run into when they run a concentrated portfolio is that they turn into buy-and-hold investors and don't actively manage their risk. They do their research, buy the stock, and then sit and hope it works out over time. Sometimes, it does, but when it doesn't, the losses are very significant and undermine the overall level of success of the portfolio.
If you are going to run a concentrated portfolio, you have to be active and not passive. The more concentrated the risk in your portfolio, the more work you have to do on fundamental research and money management. You cannot allow the losses from a poor selection to grow too big. It is overly simplistic, but the goal is to keep losses small and let your winners run.
There is an old saying not to put all your eggs in one basket, but if you do, then make sure you watch that basket. The same holds when you are running a concentrated portfolio.
(AAPL and BAC are holdings in TheStreet's Action Alerts PLUS portfolio. Want to be alerted before the portfolio buys or sells these stocks? Learn more now.)
At the time of publication, Rev Shark had no positions in any securities mentioned.
