I recently sat with a prospective client who had an investment account worth
about $450,000 held with a large, well-known US asset-management firm. As I was
reviewing his holdings, what struck me the most was the amount of stocks he was
holding. I counted more than 150 individual companies.
I asked him how
much he was paying in fees, and he answered 1.25 percent per annum. I couldn’t
believe it. I have no problem paying fees if you are getting value added for
your money, but to pay a lot and end up buying “everything” is silly.
explained that he could own a few index funds or Exchange Traded Funds (ETFs)
that track market indices and accomplish the same thing he is paying 1.25% for,
for a fraction of the cost.
The reason that he went to this well-known
firm was because he (and they) believes that buying and selling individual
stocks is an effective way to build wealth; that’s very reasonable, but shame on
the firm for marketing themselves as professional stock pickers and then buying
150 stocks. For the 1.25% fee they should be investing in what they truly
believe in, not investing in trying to cover their behinds.
many investors face is how many stocks they should own, in order to be well
diversified and to have an individual security actually make some kind of impact
on their account value. We have all heard stories told about the old lady who
bought a few shares in Coca Cola 60 years ago and now donates millions and
millions of dollars to some university. She put all her eggs in one basket and
it worked out. But is this the right strategy for you?
Can statistics lie?
three recently published studies, 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. CNN Money reported that one study
found, on average, investors whose portfolios were dominated by one or two
stocks outperformed the most diversified stock owners by 0.8 to 4.8 percentage
points annually. In the same study, roughly 8% of the top performers had their
portfolios concentrated in a single stock.
But although this sounds very
encouraging, this study also showed another side to this situation. First of
all, people with concentrated portfolios appeared very prominently among the
lowest-performing investors who were surveyed. The reason for this was that many
of them had portfolios consisting of a couple of stocks that ended up dropping
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 show very
Putting this into perspective, for every story that we hear
about the lady 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.
Look out below
It’s important for investors to note that
even stocks that seem safe can turn into anything but. If we turned back the
clock 20 years and asked investors for 20 safe stocks, I would be willing to be
that at least a handful of those companies have gone bankrupt, are on the verge
or bankruptcy or have seen their share prices decimated. Sprint, Kodak, General
Electric, Lehman Brothers and Fannie Mae are just a few of the names that fit
What’s the right amount?
During the 1960s, most
financial advisers believed that 12 to 30 stocks were necessary for
diversification. Well-known economist Burton Malkiel, author of the classic A
Random Walk Down Wall Street, concluded that this amount of stocks could
eliminate most of the element of risk from a portfolio. (At this time, “risk”
was defined as the chance of suffering big swings away from the average market
return.) Interestingly, in 2001, Malkiel found that it took 50 stocks to get the
risk reduction that 20 used to provide.
Similarly, in a recent
Seekingalpha.com article, Roger Nussbaum wrote: “If you can accept that anything
can fail, then the issue of position sizing becomes critical. This has been
covered here many times in terms of targeting individual stocks at 2% to 3% of
the portfolio as many others go with larger weightings for their holdings.
Getting caught in something that fails is not the worst thing that can happen to
an investor because it can happen to any company. It is bad to get caught with
10% of the portfolio in something that fails, and this happens.”
Malkiel and Nussbaum are in the camp that says you need somewhere between 30 to
50 different stocks. My own personal preference is in the 30 range. Most
investors can’t keep track of 50 stocks. With 30 you can still know what is
going on at each company, but you have enough diversity to lower portfolio
volatility. Nonetheless, whether it’s 30 or 50, I think we all agree that 150 is
way too much!
Aaron Katsman is a licensed
financial adviser in Israel and the United States who helps people with US