Diversification:
Diversification gets a lot of attention and in general I think people worry about it too much. I’ll break down my thoughts here and explain why I think holding 10-20 stocks is the ideal amount.
First off, the purpose of diversification is to spread risk, or reduce the risk of your portfolio. Don’t put all your eggs in one basket would be the saying here. Diversification reduces company specific risk – things happen in business and companies that look promising can blow it. They happen, and diversification reduces the consequence of this on your portfolio. If you want to get rid of all company specific risk, you would invest in all the companies aka the market basket of equities (Like the SPY), but this also limits your potential to beat the market (the SPY). Can’t beat the market if you own all the stocks that contain it (unless you change the weightings).
Anything under 10 stocks provides little diversification and depending on the quality of stocks your buying 10 may be too little as well. Anything over 20 stocks and you’ll lose the ability to successfully monitor them properly. Keeping on top of over 20 different companies becomes burdensome and at this point most of the risk has been diversified away already. Plus, that 21st stock you decide to add probably represents a company that is nowhere near as good as some of your top picks, so why buy it?
Allocation:
This leads to allocation. Let’s say you own 15 stocks, a portfolio composition will always total to 100%, so if you were going to invest in all companies equally you would have allocated 100/15 = 6.67% to each company. Realistically this isn’t going to happen, and it shouldn’t happen. Go look at any professional’s portfolio (refer dataroma.com) and they don’t hold stocks equally. Why? Two reasons. First you usually have a best if not couple of best ideas, your top 3 stocks probably have a better risk/reward relationship than the bottom 3, so why would you invest equally in them? The second reason is weightings divert over time, some stocks will take off, some will chug along, and some will languish. This will automatically change the weightings you hold in each stock.
As a rule of thumb, I never want to invest more than 10% in any one company, now if a stock is initially 10% of my portfolio and then grows to 20% that’s great! It means the company has probably been do well and the stock price is being rewarded (or all your other companies lost value – hopefully not the case) and takes up a bigger percentage or allocation in the portfolio. This is great but comes with its own problem, 20% of your portfolio is invested in just one stock and this increases the company specific risk in the portfolio. As a rule I don’t want to spend more than 10% of my portfolio’s capital buying a stock (I must be very confident) and don’t want to hold more than 20% of it (Too much risk) and so I start trimming any amount past 20% to bring it back below the ceiling.
