What’s the right number of stocks for you?

Your stocks: Should you try and hit a home run, or settle for building a portfolio of singles?

By AARON KATSMAN
February 16, 2011 23:00
3 minute read.
Trader watches the stocks

Trader watches the stocks 311. (photo credit: AP)

 
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Pitchers, catchers, baseball and stocks; what do these have to do with each other? The answer is whether you should try and hit a home run or settle for building a portfolio of singles. A question that investors frequently ask is how many stocks they should own. Should an investor put all of his money into a handful of stocks in an effort to “hit a home run,” or should he spread out his funds amongst dozens or even hundreds of stocks to try and grow his portfolio at a slower pace and try for a single?

Many stories are told about the old lady who bought a few shares in Coca-Cola 60 years ago and now donates 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?

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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 reports that one study found that, on average, investors whose portfolios were dominated by one or two stocks outperformed the most diversified stockholders by 0.8 to 4.8 percentage points annually. In the same study, roughly 8 percent of the top performers had their portfolios concentrated in a single stock.

Although this sounds very encouraging, this study also showed another side of the situation. First of all, investors with concentrated portfolios appeared 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.

Among a large group of people whose portfolios are mostly in one or two stocks, the lucky few with “superstock” portfolios (ones that can generate returns to the tune of hundreds of percent) make the group’s average return look great, even if the vast majority of individual members get very poor results.

Putting this into perspective, for every story that we hear about the overnight tycoon 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.

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I once met a man who had sold his hi-tech company for about $550 million and made about $40m. after taxes. When he expressed his desire to sell all of his stock to realize his windfall, 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.

When I saw this man about five years later at a wedding, I asked him how he was. He told me 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.

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 that 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. Others estimate that true diversification requires hundreds of stocks.

What to do?

While we would all like to get rich from owning one or two stocks, reality has shown that this will not happen for 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. Nonetheless, many clients still want to try and hit a home run.

A solution to this dilemma is found in the way you arrange your portfolio. Ninety percent of the portfolio could be invested in a well-allocated manner, and the remaining 10% could be put into two or three stocks that have the potential to soar. A correct decision will make decent money, but a wrong one won’t impact the overall portfolio by too much.

aaron@lighthousecapital.co.il

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

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