If you are a stock investor, especially someone who has just begun exploring the world of stocks, chances are you’ve wrestled with the same doubt. How many stocks should you own in your portfolio to achieve the desired level of diversification? While the answer is not straightforward, let’s discuss the approach you can take to arrive at a satisfactory conclusion. Read On!
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How much of your portfolio should be in one stock?
For any investor, it is safe to say that no single stock should be more than 5-6% of the entire portfolio, as suggested by Seth Klarman, a successful investor and author. This is Rule No 1 of stock investment. Whatever the other rules are, Rule No 1 always holds true.
In his book, the “Intelligent Investor”, Benjamin Graham has mentioned that one can build a perfectly diversified equity portfolio with 10 to 30 stocks.
However, you need to understand that the number of stocks in one’s portfolio is not about “random investing”.
In fact, equity investment is anything but random investing. Everyone has their own styles of investing and hence need to choose the stocks according to his own risk appetite and sector preference.
For example, an aggressive investor may opt for growth stocks while a sector biased person might opt for a heavy exposure in a particular sector.
The truth is that there is no one size fits all solution and many factors need to be taken into account to arrive at the ideal number of stocks in your portfolio.
Factors to consider while opting for the ideal number of stocks in the portfolio.
Here are a few factors that will help you decide how many stocks you should buy.
1. Tolerance to risk
This is an obvious factor that needs to be accounted for: Your own tolerance to risk. It would help you choose an industry, sector, stock, etc. once you are aware of your own risk appetite.
Let us understand this with an example. If the stock of one company tanks or underperforms, the impact on your overall portfolio is minimal if the percentage holding of that particular stock is low. Hence, the first rule of investment holds true here.
2. Return expectation
As the number of stocks in your portfolio increases, the overall returns on your entire portfolio usually decreases.
This is because some stocks in the stock market usually out-perform the others while most stocks give an average return.
So, the high returns of a few good stocks average down due to the performance of other stocks in the total portfolio.
So, higher the return expectation lower should be the diversification, so that you can concentrate on certain companies only, provided you have complete confidence in them.
3. Research Capability and Bandwidth
Quality of research and quantity of information you gather before making an investment play an important role in the concentration/diversification of stocks in your portfolio and to decide how many stocks should you buy. There are a number of aspects that you need to consider for your research like:
a. The company’s fundamentals:
Fundamentals need to be analysed before opting for the stock which includes earnings, profitability, projected annual cash flow, annual reports, performance and operating margins. Opting for a company is like marrying the same. You need to be 100% confident in the growth propositions of the company and then choose to be a part of the same. Higher the operating margins, the higher is the efficiency of the company.
b. Capital Structure:
Capital structure of the company is an important parameter. A conservative capital structure is a good indicator of stability and liquidity so that the company’s dependence on long-term debt is low.
Management is a key performance indicator of the company and a stock performs well only if the management is focussed and growth-oriented. So, research about management is also of the utmost importance.
If you have researched well then you can focus on a concentrated portfolio to maximise returns.
4. The time horizon of investment
Stocks give the best returns over the long-term. Some stocks do give overnight returns, but that is not a sustainable portfolio. Value investors who wish to create a healthy stock portfolio should not depend on overnight returns. Equity is a long term investment and most people use the ‘buy-and-hold’ for the same.
Pro Tip: The higher the duration of your investment, the lesser you need to diversify to maximise returns.
5. Importance of Cash Buffer
More than the ideal number of stocks in a portfolio in India, the trickier question is the level of diversification.
While some investors believe that they should remain invested 100% of the time, others like to have a healthy cash balance for investment opportunities that might come at any point in time.
However, the financial crisis situations have proved beyond doubt that being 100% invested at any point in time might not be a great solution as a crisis can come without prior notice and the correction might be much lower than your risk tolerance.
At this point withdrawing your investments may lead you to incur a loss. So, having a cash buffer is a healthy habit. Having 15-20% of the cash balance of the entire portfolio gives you a buffer to even invest when the market tanks!
Thus, for most investors the number of stocks in their portfolio should ideally between 15 to 25, depending on the investment strategy.
The investment strategy also determines how many stocks you should own; whether you want a concentrated portfolio of high dividend-yielding blue-chip stocks or if you are investing in high growth small cap stock or diversify it to a larger number of stocks to lower the overall risk of investment. The final decision is actually yours.
As stated by Joel Greenblatt, a value investor says, “Over the short term, Mr. Market acts like a wildly emotional guy who can buy or sell stocks at depressed or inflated prices but over the long run, it’s a completely different story: Mr. Market gets it right” in The Little Book That Beats the Market. So, one must diversify but not overdo it as the stock market does know how to play it right anyway.