Your Investments: How many stocks should you own?

May 2, 2012 23:51

The question 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.

Tel Aviv Stock Exchange.

stock market 311. (photo credit:GIL COHEN MAGEN / REUTERS)

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.

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I 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.

The question 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?
In 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 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 show very poor results.

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 this description.

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 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.”

So both 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!

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Aaron Katsman is a licensed financial adviser in Israel and the United States who helps people with US investment accounts.

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