If you have been investing for more than a year, chances are, you've heard the words 'diversification' tossed around once or twice.
A question I get asked a lot is 'how many stocks should I own?'
At the end of the day I truly believe it comes back to two things: risk tolerance, and knowledge.
Risk tolerance is a straightforward concept but it is not easy to measure. Most rational people prefer less risk to more. But risk is defined by most experts as the random movements in share prices, known as volatility.
People tend to do silly things during times of uncertainty, when share prices are jumping all over the place, which is why advisors do what they can to protect you from these random movements.
Knowledge, or understanding the financial markets, goes hand-in-hand with risk tolerance.
For example, if you know — or estimate — the probability of National Australia Bank Ltd. (ASX: NAB) going bankrupt, you probably won't get concerned if its share price drops 10% tomorrow. If you didn't know anything about the company, or how sharemarkets work, you may be inclined to sell your shares only to find it bouncing back the next day.
I'm comfortable holding less than 10 shares in my portfolio because I know the companies and how the market works. You may not have the experience or the knowledge of someone like me, so holding 50 stocks may be appropriate (provided they are good picks).
That is my opinion.
How many stocks should I own?
In academia, there is a different take on diversification. They say there are two types of risk:
- Undiversifiable, or systematic or market risk: the risk that affects every stock. For example, volatility, the general ups and downs of the market, cannot be diversified away.
- Diversifiable, or unsystematic risk: risks that can be avoided. This may include company or industry specific issues like plant closures, accidents or disruption.
Basically, diversification only helps us remove the second risk: unsystematic risk. For example, BHP Billiton Limited's (ASX: BHP) tragic dam wall slide in 2016 cost the company billions of dollars and its share price tanked. If BHP was your only resources stock, you would have been hit hard.
However, if you held shares of its rival Rio Tinto Limited (ASX: RIO), 10 other resources businesses and shares outside of mining, the damage to your portfolio would have been far less. That's diversification.
Often, you will see charts that look like the one above. This is a rough chart I drew, but you can see that the benefits of diversification lower the portfolio's risk to slightly more than that of the 'perfectly diversified' portfolio, noted by the grey line. This 'undiversifiable risk' is also called 'market risk'.
Ben Graham, the mentor of Warren Buffett (the world's third richest man), believed holding 10 to 30 stocks provided enough diversification. Evans and Archer (1968) found that 10 stocks was enough to remove most of the risk.
According to the Efficient Frontier, holding 20 equal size positions lowers portfolio risk by 70%.
Foolish Takeaway
If you are new to investing, it makes sense to keep yourself diversified — hold more than 15 stocks. However, don't build your portfolio for its own sake. After all, does it really make sense to add $1,000 to your 50th best idea or double-down on your first? Get to 30, then keep adding to your best ideas.
