Conventional wisdom is that the best way to manage your portfolio is to own as many stocks as you possibly can. Modern portfolio theory introduced the concepts of systematic vs. idiosyncratic risks. As with most things in finance, these are extremely fancy words to describe simple concepts.

Systematic risk represents the normal risks of investing in stocks; you can’t escape from them. When a pandemic hits the global economy in 2020, your stock portfolio is going to drop. Idiosyncratic risk is an additional layer of so-called ‘risk’ that you bring upon yourself by not having enough diversification. If you owned one airline stock in 2020, then you got hit on two fronts. The first was the general economic conditions drove stocks down. Then you got hit because you put all your eggs in a basket that did particularly bad.

The first risk was inescapable, the second was self-inflicted. It wasn’t foolish to own an airline stock, it was just foolish for that to be the only thing you owned. So you bore a risk that you really didn’t need to; you could have just owned more stocks.

So, then the question becomes, well how many stocks do you really need to own in order to remove this unnecessary risk?

How Many Stocks Does It Really Take to Be Diversified?

Edwin Elton and Martin Gruber wrote a book called "Modern Portfolio Theory and Investment Analysis.” They concluded that the average standard deviation of a single stock portfolio was 49.2 percent. In plain English, that means that owning a one stock portfolio is extremely risky. Its average return may be, say, 10%. That 49% standard deviation means that in 68% of observations, we would expect the portfolio to be somewhere between up 59% and down 39%.

That’s a ‘normal’ year. In an abnormally volatile year, we might expect the portfolio to be up or down more than that.

The more stocks you add to the portfolio, the lower this ‘risk’ goes. Now, some would argue that standard deviation doesn’t measure actually risk very well and I would tend to agree with them. For now, however, let’s just agree to go along with using volatility as our risk measurement.

Elton and Gruber found that, not surprisingly, your volatility decreased as you added more stocks to the portfolio. A 2-stock portfolio was less volatile than a 1-stock portfolio; when one stock was down big, the other might be up big, which would offset the risks.

Once you own 20 stocks, the risk was reduced to under 22% or more than half the 1-stock portfolio. Beyond that, the benefits of adding an additional stock do not add much diversification. Going from 20 stocks 1,000 stocks does reduce volatility, but only down to 19.2%.

Adding 19 additional stocks to your portfolio reduced volatility by 27.5%; the next 980 only reduced by 2.5%. The evidence suggests that the bulk of the diversification benefits occur with relatively few stocks. There are other arguments for owning fewer stocks, as well.

Diworsification

There are some areas of life where it pays to focus. Consider, for example, your career. You could spend a year of your life learning a completely new career; always moving from one job to another. Or, you could spend 30 years of your life in the same career. In which case do you think you will have better results? Surely, in the latter. By focusing all of your attention on one thing, you can achieve far better results than if you fragmented your attention.

Peter Lynch coined the term ‘diworsification’ to describe a business that spreads itself too thin. Resources are focused away from the main business model and splintered across tens or even hundreds of less important business lines. The lack of focus eventually destroys itself.

The same thing happens with investing.

There are not that many great companies out there. A Fortune study found that over a 10 year period, there were only 25 out of 1,000 companies that earned a 25% return on equity (ROE) with no single year below 15%. An astounding 24 out of 25 of those companies outperformed the S&P 500 index.[1] If you had owned all 1,000 companies, you would have owned these winners; however, your results would have been diluted by the poorer performing businesses. It would have been far better to own the list of 25 and forget the other 975.

It’s also difficult to keep track of 30 or more businesses, particularly if you have a full-time job and/or family obligations. Remember, many mutual fund managers spend their entire careers trying to beat the market; yet, few actually do. Imagine the additional difficulty of doing so with just a few hours per week. It’s going to be tough; the only way to know your businesses to the degree that you need to is to own few enough of them to be able to pay attention to how the company is doing over time.

What Do the Great Investors Do?

That’s why many of history’s greatest investors have advocated focusing your portfolio on a few best ideas. John Maynard Keynes, Warren Buffett, Charlie Munger, Guy Spier, Monish Pabrai, Seth Klarman, and many others have advocated owning a more concentrated portfolio.

Warren Buffett has said that if he and his business partner Charlie Munger were managing anything less than $200 million, they would invest 80% of their assets in 5 stocks; 25% would be in one stock.

John Maynard Keynes, the famous economist, grew King’s College assets 5x in a period where the broader UK market declined. He, also, was an ardent proponent of owning concentrated portfolios.

So that leaves a fairly substantial canyon between what most so called ‘experts’ would recommend and what some of the world's greatest investors would recommend. So what is the answer to this, apparently, perplexing disagreement? Is it right to diversify your portfolio as much as possible? Or is it better to own only a few stocks?

In this particular case, I think both are correct. What matters is whether or not you have a competitive advantage against other investors; are you above-average, average, or below-average at identifying companies that will produce more value long-term than you have to pay for them today?

Restaurants: Would You Rather Own 1,000... Or 3?

Let’s say that you lived in a town with 1,000 different restaurants. Over the next 10 years, a third of these restaurants will go bankrupt, another third will produce a return of 5% per year, and the rest will produce a return of 10% per year.

You have the choice between investing $1,000 in each restaurant or $100,000 in 3 restaurants. Which would you choose?

If you invest in all 1,000, you can be guaranteed to earn the average return, which is 5% per year.

If you were to choose 3 restaurants, your expected return would be the same 5%. However, your results could also be quite extreme. If you choose great restaurants, you might earn a 10% return — double what you would have earned just owning all 1,000. At the same time, you could earn 0% if you pick poorly.

The Key: Investment Skill

Whether you invest in 3 restaurants or 1,000 all comes down to how skilled you are at picking restaurants. If you are someone that knows a lot about the restaurant industry, perhaps, or you have connections to those that do; well, then you would probably prefer to choose 3 instead of taking the average result. You are more likely to have above average results.

If you have no skill or below-average skill, you’re more likely to earn below 5%. So you might as well just pick all 1,000 and take the average return.

It is the same thing with investing. If you know what you are doing and have the skills to select better businesses than average at or below fair value, you would do better to divide your investment amongst a smaller number of the very best opportunities.

That’s why Warren Buffett and Charlie Munger have focused Berkshire Hathaway on just a few big positions in a few businesses like American Express, Apple, Coca-Cola, GEICO, and BNSF railroad.

Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing. -Warren Buffett, CEO of Berkshire Hathaway

The issue is that being a skilled investor requires either having special knowledge about a company or the ability to analyze publicly available knowledge better than average. And, in this case, ‘average’ represents many teams of the smartest people (and computers) on Earth. To be better than the collective wisdom of all of them is quite an accomplishment. Don’t underestimate the difficulty level.

If You Don’t Think You’re Above Average

If you are someone that says, “You know what, I am pretty much unskilled at investing. I do not have the time, the talent, or the energy to become skilled enough to beat the market.” If that’s you, your humility is admirable. Most people do not realize or fail to admit that they may not be above average at investing. Unskilled investors should err on the side of maximum diversification.

That way, you really don't need to know anything about any stock, all you really have to do is get your asset allocation correct. Make sure you have a long time horizon over which to invest and just diversify your portfolio as much as possible. By doing so, you are going to achieve the average result of the market and, by achieving the average result, you are very likely to outperform about 90% of other people that are watching this YouTube channel.

The Barbell Approach to Diversification

The key is knowing whether or not you have skill. Without that, focusing on fewer stocks could be dangerous to your long-term net worth.

If you think you have some investment skill or can acquire that over time, what should you do? Should you go all in on a concentrated portfolio of just a few stocks or should you broadly diversify?

If you don’t know whether you have skill or not, I might suggest what I call the ‘Barbell Approach’ to portfolio diversification. In this case, you own two portfolio buckets and assign different amounts of money to each depending on how much experience you have. We’ll talk about that in a second.

First, here are what each bucket would look like:

Portfolio #1: Broad Diversification

The first portfolio you have is a broadly diversified portfolio using an index fund that has at least 100 holdings. This ensures that your portfolio has an adequate amount of diversification. With this portfolio, you accept that you will earn the long-term rate of return that the market (or whatever passive basket you choose) will produce.

For example, let’s say you decide you want to own every stock on the entire planet. You could buy Vanguard’s Total Market Index (VT) and have instant maximum diversification across every stock in every country on Earth. It doesn’t get any more diversified than that.

That means you give up the chance to beat whatever index you choose, but you also substantially eliminate your chance of running your portfolio into the ground with bad stock picks.

Portfolio #2: Concentrated Best Ideas

The second portfolio is your attempt to outperform the average stock, so this portfolio should be focused on your very best ideas. How many stocks should be in this portfolio?

If you are supremely confident in your stock selection skills, as in you think you are the next Warren Buffett, then perhaps you might follow his advice and invest 80% of the portfolio in 5 stocks. That is an extreme example, but one that may be appropriate if you are confident enough in your abilities and your stock ideas.

For most people, that’s too extreme. Benjamin Graham suggested a portfolio of between 10 and 30 stocks. Research suggest that is likely to be the sweet spot for maximizing potential returns while providing some protection against 1 or 2 of your stocks performing poorly — even going to zero.

How Much for Portfolio #1 and Portfolio #2?

The most important part of the barbell approach is to know how much to put in each portfolio. If you put too much in the diversified bucket, you’re going to always earn the diversified buckets’ average results. And if you wind up beating the market, then it won’t make enough of a difference to really help you.

On the other hand, you don’t want to start out putting too much in the concentrated bucket. If your investment results are really poor, you don’t want to wreck your future.

Here is one way you could do it.

If you have less than 1 year experience managing individual stocks, invest 1% of your assets into a concentrated individual stock portfolio. Of course, this is likely going to be a pretty small amount, but that’s a good thing. If you really screw things up, it won’t hurt you that badly.

Each subsequent year, evaluate your concentrated portfolio’s results compared with the diversified portfolio. If you are satisfied with how you are doing, then double your allocation to the concentrated portfolio.

In year #2, you would invest 2% in this fund. Year #3 would be 4%, then 8%, then 16%. Each year, evaluate how you have done relative to your passively managed, diversified portfolio. If you find your results are meaningfully worse after 5 years, then it’s probably best that you stick with a broadly diversified portfolio. You have proven that your stock selection skills aren’t above-average.

If, on the other hand, you find you are having success, you might consider continuing to increase your allocation to the concentrated portfolio. If you keep at this pace, you will be managing 100% of your own portfolio in a concentrated stock portfolio by year #8. If you can demonstrate market-beating performance over the long of a period, then perhaps you really do have investment skill.

If not, then you’ll probably find out soon enough that your stock picking skills are poor. And you’ll find that out well before you have enough money invested in the concentrated portfolio to hurt yourself too badly.

[1] Huber, John (2014). 1987 Berkshire Letter and Buffett’s Thoughts on High ROE. https://sabercapitalmgt.com/1987-berkshire-letter-and-buffetts-thoughts-on-high-roe/. Accessed 15 May 2021.

Disclaimer: This is entertainment only, not investment advice. All opinions expressed are my own. Any stocks or ETFs mentioned may be owned or taken a position within the next 48 hours. Neither the information nor any opinion expressed it so be construed as a solicitation to buy or sell a security of personalized investment, tax, or legal advice. This is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. The information herein was obtained from various sources. Dividend Growth Machine LLC does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Dividend Growth Machine LLC assumes no obligation to update this information, or to advise on further developments relating to it.