How many stocks should you hold?
Published in the ASX Newsletter, June 2015 by Dale Gillham
We have all heard the mantra that we need to diversify to reduce risk, but the majority of investors do not really understand diversification in its true sense, nor the inherent risks.
According to the financial services industry, you can achieve greater diversification by investing in managed funds rather than investing directly yourself. This is based on managed funds being able to hold anywhere between 30 and 100 different stocks in their portfolios. To the investor, this probably sounds logical. But following this mantra often leads to poor returns and actually increases risk rather than decreases it.
Over the years that I have been teaching and supporting traders and investors, I have seen portfolios constructed as per the above industry mantra, with 30 stocks or more. Typically, I found a third rising, a third going sideways and a third going down, with the portfolios inevitably having achieved, at best, average returns.
In this article, I will explain how managing your portfolio can be different with a little know-how. By simply removing the shares that are falling in price, your returns can increase while risk falls.
Another critical aspect of portfolio management is that in holding lots of stocks, your individual position size is typically less than 4 per cent of the total value of the portfolio. Therefore, even if some perform well, individually they are likely to have a negligible effect on overall return. What is the point in holding so many different shares when the advantages are just not there?
To understand this, we first need to look at exactly what risk is. In any market there are only two types of risk – market risk and specific risk.
Market risk is simply the risk of the market you are investing in. It is also called systemic risk, which means, when you invest in a market like shares you are exposed to the risks inherent in that market. Such as economic influences of inflation, interest rates and government policy, as well as the country’s social mood, which all affect the market.
Therefore, market risk remains regardless of the degree of diversification in your portfolio.
This is an important point to note because you cannot diversify market risk through buying more shares; you can only take more of it on with every investment in that market.
As mentioned, diversification implies a reduction in risk. However, a huge portfolio of shares is actually over-diversified as it is exposed almost exclusively to market risk. This means the portfolio will track all of the ups and downs of the market and, therefore, it makes sense that market risk cannot be eliminated by diversification. Let me explain further.
Many investors believed the industry mantra about diversification, but the GFC showed differently. Diversifying your portfolio across many stocks cannot reduce market risk, but it can, as mentioned, lead to mediocrity in terms of your return, and prevent you from sleeping at night whenever the market falls.
If you are willing to just track the market, with all of its ups and downs, you may as well just invest in an index using an exchange-traded fund (ETF), rather than holding all of those stocks directly.) However, in my opinion, there’s a better way.
Specific risk refers to the risks inherent in a company, or its operations. You can see the effects of specific risk, particularly around reporting season if a company disappoints the market, because the share price can fall quickly. Ironically, this is what the managed funds attempt to address with diversification. The good news is that specific risk can be diversified.
As an extreme example of specific risk, let’s say you put all your money into one share, which I don’t suggest you do. Your specific risk would be very high, as it is based on the fate or fortunes of one company.
I recall meeting a man years ago who knew very little about the market and in the late 1990s was advised to put all his money into Telstra, and to leverage the investment. He was highly geared when Telstra shares took a tumble in 2000 and his investment was wiped out.
Remember that your total risk is the sum of the market risk and the specific risk of the individual holdings. Holding lots of stocks means taking on more market risk and lower specific risk, whereas with fewer stocks you have less market risk and more specific risk. I will explain how many shares you personally need to hold later.
Before I do, you need to be aware that specific risk can be influenced by the risks associated with a particular sector of the market. A recent example would be the fall in the oil price, which has an effect on all companies in the energy sector that derive earnings from oil.
Not understanding risk and learning how to directly invest safely, and with confidence, has meant generations of Australians have carried the belief that the market is high risk and dangerous, and this has kept them from building real wealth.
As someone who has worked with thousands of people learning to safely invest in or trade the market, I can say it is not the sharemarket that is high risk, it is the people who do not take the time to gain enough knowledge. Investing without knowledge is gambling.
The question you need to ask yourself is, are you prepared to gain the knowledge and use it so you make better returns?
How many stocks to hold
It has been proven that you only require between five and 12 stocks in your portfolio to diversify your specific risk. However, keep in mind that the lower the number in this range, the more specific risk your portfolio will have and, therefore, the more experience you will need to manage the risk.
An experienced trader may decide to hold fewer stocks while looking to achieve higher returns. Whereas an investor with a medium to longer time horizon would look to hold a larger number of shares, between eight and 12, which enables them to reduce portfolio volatility without dramatically reducing returns. Remember that increasing your portfolio beyond 12 stocks exposes it to more market risk and this often reduces returns.
As you really do not get more benefit from diversifying more, it stands to reason that investors should ignore the financial industry’s mantra. Especially given that anyone with a little bit of knowledge can take control of their own portfolio and invest directly in shares to get a better return.
There is only one more part to getting better returns and that is, to understand money management and stop-losses, but we will leave that for another day.
To learn how you can gain the required knowledge and skill to ensure your success in the stockmarket click here.
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