What’s the right number of stocks to own? - opinion

C.J.’s quote actually opens up an interesting question about how to diversify. Financial pros constantly preach the need to diversify a portfolio but the question that remains is how to actually do it in practice. A question that I am often asked is: How many stocks should an investor own? Should an investor put all of his/her money into a handful of stocks in an effort to “hit a home run,” or should he/she spread out her funds amongst tens or even hundreds of stocks to try and grow her portfolio? Many stories are told about the old man who bought a few shares in Coca Cola 60 years ago, and now donates millions and millions of dollars to some university. He put all his eggs in one basket and it worked out. But is this the right strategy for you?

In a study done by Ivkovic, Sialm and Weisbenner, investors who had a more concentrated portfolio – i.e., they owned a smaller amount of stocks – actually showed better returns than those with a lot of stocks. They found that, on average, investors whose portfolios were dominated by one or two stocks outperformed the most diversified stock owners by 0.8 to 4.8% annually. In the study, roughly 8% of the top performers had their portfolios concentrated in a single stock.

However, although this sounds very encouraging, this study also showed another side to this situation. First of all, investors with concentrated portfolios appeared very prominently among the lowest performing investors that were surveyed. The reason for this was that many of them had portfolios consisting of a couple of stocks that ended up dropping strongly. Across a large group of people whose portfolios are mostly in one or two stocks, the lucky few with superstock (stocks that can generate returns to the tune of hundreds of percent) portfolios make the group’s average return look great, even if the vast majority of individual members in fact show very poor results.

Putting this into perspective, for every story that we hear about the one who made millions in Coca Cola stock, there are many more stories that go unreported of investors losing substantial amounts of money trying to hit a home run. Back in the hi-tech bubble of 1999-2000 I met a man who had sold his hi-tech company for about $500 million. From it, he made about $35m. after taxes. He had wanted to sell all of his stock in order to realize his windfall, but his adviser told him not to worry because the company to whom he had sold was very stable. His adviser reassured him that their stock would only keep rising, increasing his net worth even further. I saw this man about 10 years later at a wedding, and he told me that he had lost almost all of his money because the stock plummeted to almost zero. As he owned an expensive home, he was fortunate enough to be left with a total of about $3m.

Many financial experts believe that 20 is the minimum number of stocks necessary to see the benefits of portfolio diversification, and it’s best to go up to 30 stocks. It’s really important to own stocks in many different sectors of the economy in order to diversify. If you own 30 stocks in the same industry, you haven’t done anything.

Keep in mind that by using Exchange Traded Funds (ETFs) you can own hundreds of stocks and really globally diversify, something that would be very hard to do with just 20-30 individual stocks.

While we would all like to get rich from owning one or two stocks, reality has shown that this will not happen to the majority of us. For most investors, the tried and true way of growing our net worth is by investing with a well-diversified portfolio.