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How Many Stocks Should You Own?
Many financial advisers insist that the more stocks you own, the less risk you carry. But diversifying your portfolio isn’t as simple as it might seem.
Many personal finance advisers insist that you should diversify your stock portfolio (that is, own multiple stocks) to reduce your risk. After all, if you bet 100 percent of your portfolio on a single company and that company goes bust, you’ve lost your shirt. So, the obvious solution is to own several stocks. The more stocks you own, the less risk you should have, right?
It’s not quite that simple. Legendary money manager Warren Buffett suggests owning a handful of positions. He once quipped: “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.”
There are two extreme theories to guide how many stocks you should own. One theory says that you should diversify. The idea is that when some stocks zig, others zag. So you could diversify by sector: tech, pharma, utilities, consumables or defense. Or diversify by company size: large cap, mid cap and small cap. Or diversify by region: United States, Asia, Europe, emerging markets, Latin America, etc. If you truly embrace this theory, you may end up owning 100 or more stocks, just like a mutual fund. Are you a fund manager?
Following over 100 stocks is a lot of work. In fact, it’s a full-time job. That’s likely time you don’t have. In addition, owning tons of stocks will dilute your returns. Even if one goes up 500 percent, it barely will affect your total return.
Another theory says that you should own just a few stocks. In other words, you should be “concentrated.” You should only have 10, 15 or 20 positions. If you’re right, you will hit the jackpot. Go big or go home. But if you’re wrong, it will hurt a lot.
This is what the best professional investors do. You may have heard that a legendary investor, mutual fund manager, or hedge fund manager invested $1 million in a company that went on to triple. But you also may have heard of managers who invested $1 million in a company that tanked. Ouch. They can afford such a gigantic loss. I’m guessing you cannot.
So, What’s a Small Investor to Do?
You need to find a compromise, a happy medium between the two extremes.
One way to mitigate your risk is to never invest more than 4 percent of your total portfolio in a particular stock. If you use a 25 pecent trailing stop, that means that you cannot lose more than 1 percent of your total stock portfolio.
[For more on the 25 percent trailing stop, click here.]
Let’s take an example. Say you have a total stock portfolio worth $10,000. (I’m not implying that it’s a good idea to invest $400 in an individual stock; this is merely an example.)
If you invest no more than 4 percent in a particular company, it means that you cannot invest more than $400 in a single position. It also means that you will not own more than 25 stocks (25 x $400 = $10,000).
If one particular stock loses 25 percent, you must sell according to your trailing stop strategy. This means that you will not lose more than $100 on a particular stock (i.e., 1% of your total stock portfolio; $100 of $10,000 = 1 percent).
There is nothing magical about 4 percent, but there are several benefits to this strategy:
- It’s a compromise to manage risk, yet it allows you to have a portfolio that is not too concentrated.
- It’s simple. Simple to understand and simple to calculate.
- It limits your trading fees. Fewer stock purchases means fewer commissions — assuming you don’t buy and sell every other day.
If you limit stock purchases to 4 percent of your portfolio, you will manage risk, reach diversification and sleep better.
Dr. Phil Zeltzman is a board-certified veterinary surgeon and serial entrepreneur. His traveling surgery practice takes him all over Eastern Pennsylvania and Western New Jersey. You can visit his websites at www.DrPhilZeltzman.com and www.VeterinariansInParadise.com.