How to build a stock portfolio: How many stocks should I own?
When building a portfolio, one of the most important decisions is how diversified an investor should be. Typically, this will involve deciding how many stocks to hold. Too few and investors leave themselves open to gut-churning volatility or the inability to recover from investment setbacks. Too many, and an investor may end up with an expensive index tracker.
Making this decision can be difficult, and this isn’t helped by the fact that many market participants have wildly differing views on the subject. For example, Warren Buffett calls diversification “diworsification.” He says:
Diversification is protection against ignorance. It makes little sense if you know what you are doing.
The idea is often described as “putting your eggs in one basket but watching that basket like a hawk”. In a similar vein, Buffett also came up with the idea of a 20-slot Punch Card, giving just 20 investments an investor was allowed to make in a lifetime. Once it is punched out, investors are left with that portfolio forever. He thinks that the average investor spends too little time analysing their stock picks in enough detail and relies on diversification as a crutch to save them from this mistake.
In contrast, diversification has also been described as a “free lunch”. Harry Markowitz describes it as the only free lunch the market gives. The idea is that diversification is the only real market advantage investors can have without paying for it in another way.
So, should investors be like Buffett and avoid diworsification or like Markowitz and gorge themselves on the cost-free advantage? The answer is neither. Diversification is not simply good or bad. The correct mindset is one of finding the right level of diversification for an investor’s unique position. These are the factors an investor needs to consider:
Factor 1: How experienced an investor you are
Experienced investors can afford to have more concentrated portfolios. Experience in itself does not guarantee investment returns, nor does it mean that an investor has the stomach for greater volatility. However, experience means that an investor is likely to understand better how they react to extreme negative outcomes and have developed ways to hedge or mitigate these risks.
A novice investor doesn’t have this history to fall back on and should be more diversified as they learn how their own temperament interacts with market volatility. A greater number of investments also gives more learning opportunities.
Factor 2: The amount of investment research you're willing to do
Investors who do in-depth research into companies should be more concentrated. They are less likely to have blindspots and miss important factors that could lead to a disastrous investment. However, there is a trade-off. The more stocks an investor holds, the less time they will be able to commit to staying up-to-date with the latest news from each investment.
In contrast, investors who rely on more quantitative metrics, such as the Stockopedia StockRanks, should be more diversified. There is nothing wrong with relying on simple metrics. The long-term performance of investing in high StockRank stocks is excellent, as is simply buying stocks trading at a significant discount to tangible book value. Just that a simplified view leaves many stones unturned, and investors will not be aware of these investment risks. Therefore, these strategies require holding many stocks so that the impact of unexpected adverse outcomes from any one stock is limited.
Factor 3: The proportion of your wealth that you have in the stock market
Equities have been the best-performing asset class in most Western countries for well over a century. Anyone who wants to maximise their long-term wealth will likely want a reasonable exposure to the stock market. However, this comes with a trade-off. Stocks have also been one of the most volatile investments over the short term. Most investors struggle with the volatility of market indices, so adding in the extra volatility of holding few stocks can lead to poor decision-making, particularly if a large amount of an investor’s wealth is in these stocks.
Investors who have other assets, particularly those that are relatively uncorrelated to the stock market, will be able to be more concentrated in their stock portfolios since they are likely to be less affected by large unexpected moves in the value of this.
It is also worth bearing in mind what is called diminishing marginal utility. This means that growing wealth from £100k to £1m is likely to have a greater positive impact on life than going from £1m to £10m, which in turn will be higher than going from £10m to £100m. If an investor is already well off, then they don’t need a risky concentrated portfolio that also gives the possibility that they could lose a significant proportion of their wealth.
Factor 4: Your investment time horizon
An investor’s time horizon is primarily determined by their age. Someone just starting work and saving for retirement has a very long-term investment horizon. They have the time to recover from any short-term setbacks they may face by being a concentrated investor. Someone in their 80s may never recover if they have a concentrated portfolio and things go wrong with a few investments. The idea that we should all be in bonds or annuities at age 65 has been destroyed by the recent period of ultra-low interest rates. However, the principle that an investor should take less risk the older they are (or if they are saving for a short-term goal such as buying a house or car) is sound.
Factor 5: The amount influence or control you have over an investment outcome
Most equity investors have little control or influence on how a listed company is run. If management makes terrible decisions, the best action is to sell the shares. However, those who can exercise significant influence by holding a large stake in a company or being appointed a Non-executive Director can afford to be more concentrated investors. Note this is unlikely to extend to a company that an investor works for. They may have special industry knowledge, but unless they are board-level management, they are simply passengers along with the rest of the shareholders. Investors should be more diversified where they exercise no control or influence.
Factor 6: Your other sources of income
The impact of a severe drawdown will be much worse if an investor is relying on their investments for living expenses, such as they might in retirement. The combination of weak markets, owning few stocks that are underperforming and being a forced seller is particularly toxic. Such investors would be wise to consider diversification not just in terms of the number of stocks held but also across industry sectors and asset classes. In contrast, an investor with income from other sources, such as stable employment, can afford to be more concentrated since they are unlikely to be forced sellers of under-performing investments. In fact, those still investing from income elsewhere can take advantage of market weakness.
Note how several of these factors can pull in opposite directions. Novice investors are more likely to be unaware of what they don’t know, so they should be more diversified. Yet they are also likely to be investing with smaller amounts of money and have a longer investment horizon, so they can ride out the impact of the unknown unknowns.
Considering these factors, it makes sense why Buffett often ran a concentrated portfolio in his original fund, Buffett Partnership Limited. He was doing in-depth analysis, was experienced but still early in life and often exercised significant control over his investments. With these factors, it makes perfect sense that he would put his eggs in one basket. Not everyone is as fortunate as Buffett, though.
Making diversification easy in the real world
The problem with having a target number of stocks is that this may not always be achievable. An investor may not have enough investment ideas to reach the ideal level of diversification. So, the simplest way to implement this is to set an upper portfolio limit. That is the maximum percentage an investor will ever hold in one stock. Applying a portfolio limit recognises that some aspects of a company’s future are simply unknowable. No matter how well an investor has researched a company, there are unpredictable events that can have a significant impact on the valuation of the business.
This doesn’t mean that an investor has to implement equal-weight holdings or all investments should be at maximum weight. Indeed, it is better to limit purchases to some way below the upper portfolio limit so stocks can generate positive returns before needing to be top-sliced. If an investor can’t find enough investments to hold their desired number of stocks and maintain their portfolio limits, they can hold cash with the rest until those opportunities become available.
The Stockopedia portfolio tools can help maintain this portfolio discipline. Investors can set their minimum and maximum portfolio limits and graphically see when their holdings go outside of these.
While the consequences may not be as severe as the total loss of value that can occur in an individual stock, the same principle applies in market sectors. Stocks in any given sector are likely to be correlated in their business performance, so setting a limit for the percentage that an investor will hold in any given sector is also a wise move. Adding passive exposure in sectors or asset classes where an investor doesn’t expect to have an investment edge is a good way to increase diversification at minimal cost, even for committed stock pickers.
Err on the side of greater diversification
Even for investors such as a young Warren Buffett, where a highly concentrated portfolio would seem best, there is a big reason to err on the side of greater diversification: almost everyone is overconfident. The only group who don’t exhibit significant overconfidence are the clinically depressed, a trade-off no investor would desire.
Overconfidence in investing becomes problematic because investors are too sure about what they know. They overweight the probabilities of positive events happening and then make wrong investment decisions based on those probabilities. Overconfident investors are likely to overweight positions.
Even the great Warren Buffett may have been overconfident at times. When he ran the Buffett Partnership, the partnership rules allowed him to have up to 35% of his portfolio in one position. Over the five years to 1961, he built a controlling stake in a company called Dempster Mill, which made farm equipment, accounting for 20% of the Partnership’s funds. When Buffett removed a poor management team, the company’s bank became worried and threatened to seize the collateral backing its loan. If this company had gone into liquidation, it would have likely been a total loss for the fund. With the help of a turnaround specialist called Harry Bottle, Buffett turned things around and exited with a profit. However, reflecting on the Dempster situation much later, Buffett states that if the bank’s decision had gone the other way, his wealth would have taken a significant hit:
…hiring Harry may have been the most important management decision I ever made. Dempster was in big trouble under the two previous managers, and the banks were treating us as a potential bankrupt. If Dempster had gone down, my life and fortunes would have been a lot different from that time forward.
Most investors don’t want a single bank decision to define their investing future. Diversification removes the power for arbitrary decisions made by others to have that power.
There is no hard and fast rule for how to err on the side of greater diversification. However, a good rule of thumb would be for an investor to think about what position size they would be comfortable with in a single stock and then halve it. No method is perfect, but by thinking through these concepts in detail, and using the Stockopedia tools, investors will be towards the top of the class regarding portfolio construction.