- The modern portfolio theory states that 30 stocks are enough for a portfolio.
- However, every addition to your portfolio increases the likelihood of it being a loser.
- A businesslike perspective offers a different approach that can lead to much better returns.
There are millions of investing opportunities, from real estate, to stocks, bonds, options, derivatives, various funds, commodities, stamps, antiques, cars, and who knows what else. This makes all investors, from beginners to professional investors, very confused on what to invest in. In today’s article, I’ll give a perspective on how many positions one should have in their portfolio that you haven’t heard before.
The Typical Portfolio Allocation
The typical, modern portfolio theory allocation is one where you have almost the same risk as the market when you have more than 20 positions in your portfolio.
Figure 1: Portfolio risk vs. market risk in relation to number of positions. Source: Investopedia.
Owning more than 20, especially more than 30, stocks doesn’t really change your portfolio risk as it becomes equal to market risk. Therefore, if you own more than 30 stocks, you should really reconsider your portfolio and take a more businesslike approach.
A Businesslike Approach To Portfolio Strategy
For the purpose of this article, I’ll ask you to forget about stocks and imagine that the stock market closes for 10 years. This will allow us to have a businesslike perspective on our investments.
If there are no stock quotes to watch, the only thing to watch is business performance and ultimately earnings. Focusing on earnings eliminates stock market noise and allows you to find the best investments.
Now, nobody can tell me that every position in a portfolio of 20 stocks has the same risk reward outlook. There is definitely a few stocks that are better in your portfolio and have the best business earnings. Those business earnings, or future earnings, are in fact what will determine your long term returns. It is therefore illogical to have an equal portfolio weight in a company that offers a 15% yearly business return and one that offers a 5% return for the same risk. To quote Buffett:
“Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.”
Therefore, it all boils down to knowing what you are doing.
Do You Know What You Are Doing?
Many wonder if it makes sense to pick stocks and if it’s really possible for us to pick winning stocks. A look at the total returns of individual stocks vs. the Russel 3000 index from 1986 to 2006 shows that the task isn’t all that difficult. Well, depending how you look at it.
Figure 2: Individual stock returns vs. the Russel 3000 index from 1983 to 2006. Source: Investopedia.
In the two decade period, 64% of stocks underperformed the index while 36% of stocks outperformed the index. This means that diversifying actually lowers your returns as there is a higher likelihood of owning losing stocks.
Out of the total number of stocks analyzed, 6.1% of stocks outperformed the Russel Index by 500% or more. A 6.1% chance of hitting it big means that one out of 16 stocks will significantly outperform the market. Thus, the question remains, are you good enough to determine which one of the 16 stocks you are analyzing will significantly outperform the market in the long term.
The best way to find outperforming stocks is to analyze the company from a business perspective. This will enable you to not sell at the first price increase and to buy more in the event the irrational market offers you a better buying opportunity.
How To Look At A Company From A Business Perspective
Taking a business perspective on a company requires calculating earnings over a long period of time. This is both a simple and difficult task. Calculating expected future long term earnings on all the traded stocks is practically impossible as you need to understand not only the stock, but also the sector. However, you don’t need to do it for all the stocks out there, you just need 5 to 10 stocks that will outperform the stock market in the long term by 500% or more.
If you want 10 stocks in your portfolio, you should then look at 160 stocks in your area of expertise. For example, I’m pretty confident in the commodity environment and emerging markets where I can pretty accurately calculate risks and long term potential earnings. I don’t know what your specialty is, but I’m certain you have a few of them and are capable of finding the best stocks in your sector.
Going back to the Russell 3000 distribution of returns, in order to beat the market, you have to be better than 64% of stock market participants as 64% of stocks underperform. I find this very possible as I don’t believe that 64% of market participants have even analyzed more than 160 investments in detail to find the best ones.
Analyzing 160 investments might seem like a daunting task, but just think of the rewards if you outperform the market by 500%. By looking at the rewards, outworking others by analyzing a few hundred stocks seems easy.
Don’t listen to those who tell you that you should have lots of stocks in your portfolio because the more stocks you own, the higher the chance is for underperformance as 64% of stocks underperform.
To find the stocks that will outperform, you simply have to be better than 80% of the investors out there which isn’t a difficult thing to do if you dedicate yourself to learning about investments and especially if you take a businesslike approach where you focus on earnings and not stock prices.
Keep reading Investiv Daily as we’re always discussing investing opportunities with the goal of creating a portfolio allocation that will mostly be in the 6.1% category described above.