If you read enough books, blogs, or articles the “how many stocks” topic is bound to come up. How many individual stocks to hold in a portfolio can ignite some passionate discussion. It’s controversial and a very personal decision. And good luck trying to change someone’s mind, which is not what I’m trying to do in this article. Personally, I’m just doing some research to continue evolving my understanding on the topic.
The best way to start is to look at one of the most respected mutual funds ever – Vanguard Wellington Fund. This fund was established on July 1, 1929 (yikes – talk about bad timing) about 3 months before the Great Crash and it’s returned 8.42% on average each year since fund inception. WOW!
It’s typically a 65% stock / 35% bond mix and it’s a seriously all-time great fund. But here’s the most important metric that is relevant to our discussion. As of 3/31/21, they had 66 stock holdings for their $76 billion dollar portfolio. Think about that for a moment. If they hold only 66 stocks then why would I feel the need to hold 50, 75, or 100+ stocks?
“Diversification is a protection against ignorance.”
Warren Buffett
I think I’ve well established on this blog that I’m not the greatest guru of individual stock picking. That’s why I’m focused on quality stocks and trying to buy them at good prices. If I’m buying a large number of stocks then it probably means I can’t distinguished between companies or identify value. People define value differently and that can impact a person’s philosophy on how many stocks to hold.
I’m no genius to know that owning Johnson & Johnson or Pepsi is good for a long-term portfolio. But there are only so many of these types of quality companies available – they don’t grow on trees. Simply, the more stocks you buy the further away you get from the concept of owning quality stocks. Can it get any simpler than that as it relates to holding too many stocks?
Is There A Right Number?
The purpose of owning multiple stocks/sectors is to diversity your portfolio so that you reduce risk. The issue is knowing how many stocks/sectors is enough. If you buy everything then you might as well own a index fund versus buying individual stocks.
When you start buying individual stocks, you aren’t going to have very much diversification. The first year you might buy 5 stocks. And the second year you might buy another 5 to add to your portfolio. As the process continues you might own about 20 stocks in 5 years.
The more stocks you buy the harder it becomes to find quality at a good price. Quantity is not a substitute for quality, and this certainly applies to the number of stocks you hold. I’d rather have fewer quality than more non-quality stocks.
Investing expert Burton Malkiel, author of “A Random Walk Down Wall Street,” found that it takes 50 stocks to get the full protection of diversification. But we each need to determine what kind of “full protection of diversification” we want. And that decision will impact your returns. Though Malkiel found that 50 stocks are needed for full diversification protection, benefits start to diminish after about 25 stocks.
Benefits of diversification diminish after about 25 stocks
The greater number of stocks a portfolio has, the less impact one of those stocks has on the whole portfolio. That just doesn’t sound like the type of approach that makes much sense to me. I purchased Aflac at great value and I want the expected rise in price to positively impact my portfolio. But if Aflac is one of 100 stocks in my portfolio then its impact will be minimized on the portfolio. So many times, a portfolio rises because of just 5 excellent stocks. But if you have 100 stocks in a portfolio those 5 great purchases won’t mean much to you.
So What’s The Plan?
Let’s face it, there are only so many good investment ideas at any given time. If you focus on quality then it’s likely to limit your potential holdings a lot. That’s why I’ve only got 50 +/- stocks on my Master Stock List. I only want to own the best companies at the right price and hold them for 30+ years. Most stocks won’t even be around for 30+ years so your opportunities are limited.
In their book, “Investment Analysis and Portfolio Management,” authors Frank Reilly and Keith Brown note that in one of their studies, “about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.” The book quote, in turn, comes from a report from Morningstar that found owning more than 18 stocks in a portfolio makes it difficult for an investor to closely track the stocks in their portfolio.
So, holding 18 stocks sounds like a good starting point. What if you want to reduce your risk even more? You do what the above chart from A Random Walk Down Wall Street says and own up to 25 stocks. However, let’s consider a study that appeared over 15 years ago in the academic Journal of Finance.
The study, “On the Industry Concentration of Actively-Managed Equity Mutual Funds,” found that the mutual funds which were the most concentrated — least diversified, in other words — produced better risk-adjusted performance, on average, that the most diversified funds.
It’s starting to look like 18-25 stocks is the minimum and 50 is the maximum number for an individual portfolio. When you start going over 18 stocks (according to Morningstar) it gets harder for the individual investor to track stocks. I think it’s becoming very clear why this is a controversial topic that has raged for decades. Next, let’s discuss my current approach (which seems to continue evolving).
These Are My Thoughts
Last year, I pondered this exact topic and created my solution. I created 3-levels of stocks and know what my maximum holding is for each stock (2%, 4%, and 6%). Like my master stock list, my levels ranking changes as new information becomes available.
The “Maximum %” allows me to manage my number of stocks with quality being my guide. It means I’m willing to hold “up to” a maximum percentage of an individual stock in my overall investment portfolio. The highest quality (only 4 stocks currently identified) is Level 1 and I’ve allowed myself to hold up to 6% of my portfolio in each of these stocks.
For example, if my investment portfolio is $1,000,000 then I’m willing to hold up to $60,000 (or 6%) in Johnson & Johnson. Over time, I’m likely to move stocks up and down levels based on various factors. For example, in 2020 I moved Exxon Mobil from a Level 1 down to a Level 2.
So, where do I stand on how many stocks to have in a portfolio? Using my current approach, I need to hold a minimum of 23 stocks (all Level 1 & 2 stocks). But knowing the master stock list will evolve, I’m also aware that my holdings will vary in size. For me, that overall number will likely be around 20-30 but I’m not shooting for any specific number. Once I hit 20 stocks then I’ll be extremely opportunistic with purchases.
Today, using my current approach, I’m needing to hold a minimum of 23 stocks. This constitutes all Level 1 & 2 stocks in my master stock list.
If you only want a maximum of 1% per stock then you must own 100 stocks. At 2% maximum holdings you must own 50 stocks. But things aren’t that simple because not all stocks are created equal. Why hold only 1% of Johnson & Johnson ($445B market value), the premier healthcare company in the world, on equal par as Biogen ($40B market value)? They have completely different profiles, outlooks, and financials so why would you hold them both at 1% of your portfolio?
Summary
There may be no absolutely right number of stocks to have in your portfolio but we know owning too many doesn’t help. Owning too many starts diminishing the benefits of diversification. I see way too many bloggers talking about their 100+ stocks and it leads me to believe they really don’t understand the concept of diversification. They are just adding companies to their portfolio that went down in price. They might as well buy an index fund with that approach.
Like so many things in life, diversification is best in moderation.
Again, if Vanguard Wellington Fund can have $76B in 66 stocks then I’m sure I’ll be fine with 25 stocks for my smaller stock portfolio. I’m not a stock picking genius or guru. I’m just buying quality companies at good prices and I’m constantly learning and refining my approach. If buying one (Johnson & Johnson) of the only two AAA credit rated companies makes me a guru then guilty as charged.
The trick is trying to buy at at the right price. My approach to buying these stocks is to dollar cost average at fair prices and then buy heavier on dips. This gives me an average cost that enables my total return to build wealth 20 years down the road. Genius! (Sarcasm intended)
I’ll finish with this … if I own more than 25 stocks then it means I got my latest purchases at really (really) good prices. I’d call these super compounding stocks or deep value. If I can buy 30-40 of the highest quality stocks at deep value then I’d be fine with that. But deep value is hard to find and it’s not the same thing as fair value. Bottom Line: I’ll likely hold 20-30 stocks but I’m not targeting a specific number.
Thanks for reading!
Mr. TLR