You are probably familiar with legendary investor Peter Lynch, who gained his considerable fame managing Fidelity's Magellan Fund. The fund earned an annualized return of 29% during his 13 years running it, more than twice what the S&P 500 (SPY) (VOO) earned during that time.
Mr. Lynch is well known for his book One Up On Wall Street, where he explains that individual investors can outperform fund managers because they are unencumbered by short-term performance concerns and bureaucratic rules.
During his tenure as manager of the Magellan Fund, Lynch held as many as 1,400 stocks at some point. Such a large number didn't prevent him from creating outstanding alpha. But it's essential to understand that he did not invest in new businesses in an effort to be more diversified. He simply invested in a compelling investment every time he came across one. This distinction is essential.
There's no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors. That said, it isn't safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios, I'd be comfortable owning between three and ten stocks.
Lynch believes investors should own however many "exciting prospects" that they are able to uncover and that pass the selection process. In short, while you could have not enough stocks, there is no such thing as too many, as long as you have the right filtering process.
But make no mistake, Lynch clearly thought about portfolio construction with diversification in mind, focusing on being spread across many industries, company size, and growth potential.
In a 1985 Barron's interview, he described his strategy behind the fund:
- 30%-45% of the fund in growth stocks.
- 25%-35% of the fund in conservative stocks.
- The rest would be in cyclicals and special situations.
Lynch thinks in terms of portfolio construction with each bucket serving a specific purpose:
- The more conservative part of the portfolio is here to offer downside protection in case of a market sell-off.
- The more aggressive part of the portfolio is here to generate alpha in a bull market.
Ultimately, reducing the volatility of a portfolio should not depend on the number of stocks in the portfolio, but the overall portfolio construction and the investment selection. Investing in multiple uncorrelated assets is a powerful way to limit portfolio draw-downs without necessarily compromising your potential returns.
It's not uncommon to find individual investors who think they are taking too much company risk as soon as a stock reaches 3% of a portfolio. Yet, many are willing to take a 30-year mortgage to buy a single family home with a down payment that represents the vast majority of their financial assets at some point in their life.
The explanation is simple. Making a concentrated investment requires appropriate due diligence and usually involves a predefined goal and time horizon. If you know what you're buying and understand clearly the upside opportunity and downside risk, making a concentrated investment isn't necessarily reckless.
How concentrated your portfolio can be ultimately depends on what you put in the portfolio. If you behave like a business-owner, focusing on high quality companies that are likely to deliver outstanding returns on invested capital over the years, there is nothing wrong with focusing only on a handful of ideas.
Abnormal returns, after all, can only come from abnormal portfolios. If you need some form of concentration to deliver significant alpha, it all boils down to the intrinsic quality of the individual investments you put in the portfolio. The higher the quality of the individual bets, the more concentrated you can be.
Let's review the different factors you need to consider to think about how to build a portfolio that is right for you.
The importance of doing the reasonable thing
In his book The Psychology of Money, Morgan Housel explained the concept of being rational vs. reasonable.
Aiming to be mostly reasonable works better than trying to be coldly rational.
A rational decision means making a decision strictly based on what the facts and the numbers say. It all sounds great in concept. The implication is that you let the data make the decision for you.
The problem is that being rational is not always a realistic approach. We are all human beings with emotions at play that can get in the way of a sound plan. Sometimes, what would make the most sense for you is going to be different than the most rational decision.
What we are addressing here is portfolio suitability.
To illustrate, back testing as far as possible, the results will mostly tell you the same things again and again:
- Stocks deliver the highest return over an extended period.
- Stocks will suffer more significant draw-downs when they have a bad year.
Let's pick Jeremy as an example. He's a 40-year-old investor who has several decades ahead before withdrawing from his portfolio. The most rational portfolio allocation for Jeremy could be 100% in stocks if we solely look at more than a century worth of historical data.
But what if Jeremy is the kind of investor who deals very poorly with volatility? What if Jeremy would have been the kind of investor who sells all of his stocks at the bottom in March 2020 out of fear of a new paradigm with the pandemic taking over the world?
What Jeremy truly needs is a portfolio that he knows he can deal with under all circumstances, based on his own risk profile, goals and time horizon.
If Jeremy's main goal is capital preservation, a diversified "all-weather" portfolio may make perfect sense for him. It would be a reasonable choice.
- The best portfolio may not be the rational one - the one that can in theory generate the most alpha over the long term.
- Instead, it's the reasonable one - the one that Jeremy is not going to blow-up when his emotions are challenged the most.
Daniel Kahneman, Nobel Prize in economics in 2002 and author of the book Thinking Fast and Slow, perfectly encapsulates the idea of making decisions based on what is likely to suit you best.
He discussed previous why we hate losing money more than we like making it. Loss aversion can have a dramatic impact on our decision process.
He explains:
If you have an individual whose objective is to maximize wealth at a certain future point in time, then loss aversion is very bad because loss aversion will cause that individual to miss out on many opportunities.
But if it is rational to live with whatever your nature is and to try to enjoy life as much as possible, then loss aversion is just a fact of life, like regret.
You may think that regret is a foolish emotion, but if you know that you're going to be susceptible to regret, it is not irrational to anticipate it and to act accordingly.
It's essential to honestly assess your susceptibility to specific emotion triggers and establish an appropriate portfolio allocation.
There is a constant tug of war between our loss aversion and our optimism.
What's essential is the congruency between the risks you are taking and your correct understanding of your odds of success.
People who bail at the worst possible time often took more risks than they realized, because they managed to overcome their loss aversion without keeping in check their overconfidence.
How much is too much diversification?
Modern Portfolio Theory has created a wide range of solutions for investors to maximize their returns based on the risks they are taking. Most investors are well versed with the idea that they need to build their portfolio on the efficient frontier.
Building a portfolio on the efficient frontier means you have the right risk-reward balance.
But a key issue here is that the efficient frontier doesn't necessarily tell you if your portfolio is over-diversified - and therefore unlikely to generate alpha.
Investors who own dozens of ETFs may be properly diversified with limited draw-downs. But the alpha they can generate is likely vanishing all the same. At some point, you might as well put everything in a global index fund ETF such as the Vanguard Total Stock Market (VTI) and get on with your life. There is nothing wrong with that, and that's probably the best equity portfolio for 99% of investors.
For an individual investor, signs of over-diversification usually involve:
- Too many similar mutual funds, particularly in the same sub-categories.
- Use of multimanager products that dilute due diligence.
- Stocks bought only for the sake of diversification.
- Investments that are not fully understood.
- Over complexifying with too many alternative assets.
I recently wrote an article about the 4 Simple Rules To Protect Your Portfolio, in which I argue that the best question shouldn't be "How much volatility can you tolerate?" but rather "How can you better tolerate volatility?"
Most diversification efforts are meant to alleviate volatility.
But volatility is not the main risk your portfolio is exposed to. You are.
How about too little diversification?
I regularly come across individual investors sharing their portfolio on Twitter. Occasionally, I'll see portfolios with less than 10 holdings.
This tends to make me pause, but not for the reason you might think.
I don't see heavy portfolio concentration as an issue. My main concern is about how a portfolio can evolve if it starts with only 10 holdings and how it may force an investor into selling its biggest winners simply because they become too big.
You might think it's a good problem to have, but as Charlie Munger said:
The first rule of compounding: Never interrupt it unnecessarily.
If an initially very concentrated portfolio is likely to turn into an unbearably concentrated portfolio after a few years, then it's not really built with the long term in mind.
If you are investing for the long term with holding periods in years or decades (as opposed to days or months), a portfolio will tend to concentrate heavily into your biggest winners.
Let's imagine you are an average investor with average luck, and the stocks of your portfolio follow the historical distribution below.
![[chartzzzz.jpg]](https://static.seekingalpha.com/uploads/2021/4/7/saupload_chartzzzz.jpg)
Based on the data from BlackStar Funds analyzing more than 8,000 stocks over 23 years, here are the odds of performance of each stock.
| Returns | Probability |
| -75% & worse | 19% |
| -75% to -50% | 7% |
| 50% to -25% | 6% |
| -25% to -0% | 7% |
| 0% to 25% | 10% |
| 25% to 50% | 8% |
| 50% to 75% | 5% |
| 75% to 100% | 4% |
| 100% to 125% | 3% |
| 125% to 150% | 3% |
| 150% to 175% | 2% |
| 175% to 200% | 2% |
| 200% to 225% | 2% |
| 225% to 250% | 2% |
| 250% to 275% | 1% |
| 275% to 300% | 1% |
| 300% & better | 19% |
I have applied these odds to three theoretical portfolios that would start equally-weighted with the following number of stocks:
- Portfolio A: 10 stocks (10% initial allocation per stock)
- Portfolio B: 20 stocks (5% initial allocation)
- Portfolio C: 40 stocks (2.5% initial allocation)
Assuming the same returns (same amount of luck) generated across all portfolios spread along the return distribution above, here is how these portfolios could theoretically look like about 20 years later.
| Equally-weighted portfolios after 20+ years | Portfolio A 10 stocks | Portfolio B 20 stocks | Portfolio C 40 stocks |
| Holding 1 | 42% | 27% | 16% |
| Holding 2 | 23% | 15% | 12% |
| Holding 3 | 13% | 13% | 8% |
| Holding 4 | 8% | 10% | 7% |
| Holding 5 | 6% | 7% | 7% |
| Holding 6 | 4% | 6% | 7% |
| Holding 7 | 2% | 4% | 5% |
| Holding 8 | 1% | 4% | 4% |
| Holding 9 | 0% | 3% | 4% |
| Holding 10 | 0% | 3% | 3% |
| Top 5 Holdings | 92% | 72% | 51% |
| Top 10 Holdings | 100% | 92% | 74% |
It's essential to look at these portfolios and ask yourself how comfortable you would be with this type of concentration over time.
If you are comfortable with a position slowly overtaking your portfolio and eventually representing close to half of your allocation without feeling the urge to tinker with the portfolio, then 10 stocks might be sufficient for you.
I bet that it's not going to be the case for most investors, though.
In my view, if your concentration level is forcing you out of your winners over time, it was an over-concentrated portfolio in the first place.
In short, you should only have a 10% initial allocation to a stock if you are comfortable with that stock representing half of your portfolio one day. If that number sounds too high, portfolio B and C presented above may constitute a more relevant option for you.
It all comes down to what's in the portfolio
I want to bring up again a snippet from a previous Berkshire Hathaway (BRK.A) (BRK.B) shareholder meeting. I wrote about it previously in my article about The Delicate Art of Balancing Diversification and Concentration.
As I was researching answers to the optimal number of positions that should be in an equity portfolio, one of the subscribers of the App Economy Portfolio shared with our community the archives from the 1996 annual meeting. Responding to a question about the appropriate size of a new investment, Warren Buffett explained:
We like to put a lot of money in things that we feel strongly about. And that gets back to the diversification question.
You know, we think diversification is - as practiced generally - makes very little sense for anyone that knows what they're doing.
Diversification is a protection against ignorance.
I mean, if you want to make sure - (laughter) - that nothing bad happens to you relative to the market, you own everything. There's nothing wrong with that. I mean, that is a perfectly sound approach for somebody who does not feel they know how to analyze businesses.
If you know how to analyze businesses and value businesses, it's crazy to own 50 stocks or 40 stocks or 30 stocks, probably, because there aren't that many wonderful businesses that are understandable to a single human being, in all likelihood.
And to have some super-wonderful business and then put money in number 30 or 35 on your list of attractiveness and forego putting more money into number one, just strikes Charlie and me as madness.
And it's conventional practice, and it may - you know, if you all you have to achieve is average, it may preserve your job. But it's a confession, in our view, that you don't really understand the businesses that you own.
Charlie Munger to add:
Yeah, what he's saying is that much of what is taught in modern corporate finance courses is twaddle. (Laughter and applause)
It's important to note that while Warren Buffett holds about 50 positions in his portfolio at Berkshire, his top 5 holdings alone represent close to 71% of his allocation.
I've been very humbled by this segment of the annual meeting because it made me look at the bottom of my portfolio with criticism. I have a natural tendency to be excited about the prospects of new businesses and feel more inclined to start positions in new ideas rather than adding to my existing positions. Finding the right balance is essential.
If you've been investing for a while, there's a good chance your best ideas are already sitting at the very top of your portfolio. Most of the time, your biggest holdings are where new funds should be allocated when the story and opportunity is intact, the same way Buffett and Munger have added diligently to Coca-Cola (KO) for years.
The main factor in determining your allocation should be the nature of the investment opportunity you are looking at.
- A small biotech that has less than 50% chance of receiving an FDA approval should not represent a significant part of your portfolio.
- On the flip side, having a large allocation to multi-faceted companies like Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), Google (GOOG) or Tesla (TSLA) is not particularly concerning, particularly when you consider that these companies represent almost a quarter of the S&P 500.
Your portfolio allocation should be a reflection of your degree of knowledge and certitude. The size of an investment should be proportional to your probability of success.
An educated investment should be similar to a game of Texas Hold'em poker where you would be able to see everyone's cards and make your decision accordingly before seeing the flop, the turn and the river unfold. You have to recognize when you have a good hand with odds in your favor.
When the evidence of the success of a business is becoming more overwhelming over time, it makes perfect sense to let a position take a larger part of a portfolio, by letting it run or adding to it.
What safeguards do you have in place?
The exact number of stocks in a portfolio is not particularly insightful.
It all comes down to your allocation and how you monitor it.
In my previous article covering portfolio construction, I discussed how one of the easiest ways to avoid being carried away by your own convictions is to cap your maximum exposure to a single company from a cost-basis perspective.
What really matters is not so much the number of stocks you own, but rather the largest amount you are letting yourself add to a given stock. If that number is 10% of the funds added to a portfolio, you'll never own less than 10 stocks.
It all comes down to your risk profile, time horizon and goals. There is no right or wrong answer on what the maximum exposure to an investment should be. What matters is to have it defined ahead of time so that you can execute on a well thought-out plan without your emotions taking the best of you.
Rather than trying to figure out how many stocks should be in your portfolio, you want to determine the max level of exposure to an individual investment you are comfortable with on a cost basis, and stick to it.
Knowing your limits and having a clearly laid-out plan is one of the most important assets in the arsenal of an investor.
- How many stocks do you own?
- Do you believe there is an ideal number based on past experiences?
- Did you define your maximum exposure to a single company from a cost-basis perspective?
- If you've been investing for a while, what would you do differently if you could do it all over again.
Let me know in the comments!
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