By Ben Reynolds on May 4th, 2022 for SureDividend
Note: We previously had an article on Sure Dividend published February 8th, 2018 that was titled “How Many Stocks Should You Hold In Your Portfolio” by Charles Fournier. Click here to download a PDF of that article.
The less stocks in your portfolio, the more you can concentrate on your best ideas.
And the more stocks in your portfolio, the more you benefit from diversification.
Less is better. And more is better…
The question of how many stocks should you own in your portfolio seems paradoxical.
The key in understanding how many stocks you should own in your portfolio is looking at how much diversification benefits you gain from adding additional stocks to your portfolio versus the offsetting downside of investing money into stocks that aren’t your top choice now.
Keep reading this article to learn more about the ‘sweet spot’ between over-concentration and over-diversification.
For those looking for a quick answer: At Sure Dividend, we believe portfolios of around 20 to 30 stocks represent the ideal tradeoff between concentration and diversification.
Note: Click here to download a PDF of our 1-page to-the-point portfolio building guide from a historical edition (meaning the Top 10 is not up-to-date) of the Sure Dividend Newsletter.
The idea behind stock diversification is that by investing in multiple companies, we reduce our risk of serious loss from any one company.
These are extreme examples. But even less extreme events should give pause to investors looking to go “all in” on one stock. Take Cisco (CSCO) as an example.
Investors who purchased Cisco at its peak in the 2000 Dotcom Stock Bubble, had to wait until 2021 to break even, including dividend payments. And the company’s price has declined since, so investors who bought at the peak are still underwater on their investment 22 years later.
And this is not a knock on Cisco as a business. In fiscal 2020, the company generated $18.9 billion in revenue and $2.7 billion in profit. Fast-forward to fiscal 2021, and the company generated $49.8 billion in revenue and $10.6 billion in profit. Investors were right that the company would grow significantly. But investing a sizeable chunk of your portfolio into Cisco when it was a “can’t miss opportunity” at the absolute peak of irrational exuberance would prove to be a costly long-term mistake.
The reality is that no matter how much due diligence we do on a company, we can always be wrong about a company. We can be wrong on price, or wrong on the future prospects of the business, or both. It’s important to stay humble and admit the world is an unpredictable place.
Diversification is investing humility distilled into your portfolio.
But that doesn’t mean a near infinite amount of diversification. According toauthors Frank Reilly and Keith Brown in their book Investment Analysis and Portfolio Management,
“…about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks.”
This means it is not necessary to hold many hundreds of stocks to get the benefits of diversification. An equally weighted portfolio of ~15 stocks will suffice to get the bulk of diversification benefits.
Of course, this only holds if you are investing in companies with different risk profiles. A portfolio of 15 oil exploration companies is going to suffer badly in the event of protracted oil prices. Common-sense diversification among sectors and risk-factors is critical when thinking through the number of stocks to hold in your portfolio.
Diversification is important in constructing a portfolio that is likely to grow over time as it reduces your exposure to any one stock “blowing up” your portfolio. The flip-side of diversification is concentration.
The idea behind concentration when it comes to investing is that you should put your investment money into your #1 best idea, not your #42 best idea.
“Too much of a good thing can be wonderful.”May West
Concentrated investing has been popularized by some of the world’s best investors. Warren Buffet famously put 40% of his partnership’s portfolio into American Express at one point. Bill Ackman’s Pershing Square holds just 6 stocks.
The upside of concentration is having more of your money in the investments you expect to generate the highest returns. It’s much better to be in a stock that you expect to make you 20% a year, versus one you expect to make you 8% per year.
Concentration is related to your confidence in a particular investment. The more sure of yourself you are, the more you can put into any one investment.
That’s why concentration works well for the world’s best investors. They’ve proven they have a very high level of investing ability, and concentration helps them best capitalize on this ability.
The degree to which you concentrate in your portfolio should line up with what you’ve proven as an investor. If you track your investments, and your best ideas have consistently outperformed the market by a wide margin over several years (3+ at a minimum, and preferably a full market cycle), then greater than average concentration may be of benefit to you.
But if you haven’t proven this first, then it’s much more prudent to not assume you are the ‘next Warren Buffett’. Overconfidence typically comes at a steep price in the stock market.
Another benefit of concentration is knowing what you own. The fewer stocks in your portfolio, the more you can research and deeply understand each one. This greater emphasis on each holding should mean fewer investing mistakes.
There are clearly benefits to concentration, just as there are to diversification. We look to a “middle ground” synthesis of the two polarized concepts.
Why We Recommend A Portfolio Of 20 to 30 Stocks
The benefits of diversification trail off the more stocks you hold. The jump in diversification from 1 to 2 stocks is massive. The jump in diversification from 499 to 500 stocks is non-existent for practical purposes.
As mentioned earlier in this article, you get most of the benefits of diversification from holding just 12 to 18 stocks. At Sure Dividend, we look to be a bit more conservative, and stay just above this range. We recommend a portfolio of 20 to 30 stocks, with common-sense diversification among sectors and industries.
A portfolio of 20 to 30 stocks has enough holdings that you get the vast majority of diversification benefits from a larger stock portfolio.
In a 25 stock portfolio, if one stock doubles, that adds 4% to your returns for the year. This is a meaningful boost. And if one stock goes completely bankrupt then your wealth is not permanently impaired as the hit to your portfolio would be just 4%, which would likely be made up in less than a year by the other stocks in your portfolio, based on average historical market returns.
And 20 to 30 stocks means you are concentrated enough to really know what you hold. It’s certainly doable to check up on 20 to 30 stocks from time-to-time to make sure they are on track.
This is even more true of high quality dividend growth stocks with long histories of rising dividends. These tend to be securities that have strong and durable competitive advantages, and therefore typically need less time to “check up” on performance versus an unprofitable start-up, as an example.
The Dividend Kings list is made up of ~40 companies with 50+ years of rising dividends. It’s a great place to look for high quality dividend growth stocks. The Dividend Aristocrats list is another quality resource. It’s comprised of 66 S&P 500 stocks with 25+ years of rising dividends.
This article was first published by Bob Ciura for Sure Dividend
Sure dividend helps individual investors build high-quality dividend growth portfolios for the long run. The goal is financial freedom through an investment portfolio that pays rising dividend income over time. To this end, Sure Dividend provides a great deal of free information.