How many shares should you hold in your portfolio?

Everyone knows that you should not put all your eggs in one basket, as the loss of an entire basket will be disastrous. Such a rule applies to the stock market. So investing all our money in one or two or three stocks is risky. The question is how broad the diversification of our portfolio should be.

Do we have enough eight stocks in our portfolios, such as Warren Buffett and other gurus, or should we hold more stores than 10?

We need to understand the two main risks of investing in stocks if we want to answer this question:

Market risk.

You also called “systematic risk”, the risk of losing money due to a macro event unrelated to the companies you hold. Sources of market risk are recessions, changes in interest rates, currency changes, wars, political instability, coronavirus, and more. In these cases, even the shares of companies that will not be affected by these situations are likely to fall along with the rest of the stock market. So, unfortunately, there is nothing you can do to protect yourself from this global risk.

Risk of companies.

The second risk is losing money when buying shares of a company if something goes wrong. It is also known as “specific risk”. For example, you have purchased shares in an up-and-coming technology company that is expected to launch next-generation fiber next year. Unfortunately, one of its competitors manages to produce and found the duplicate threads six months earlier. Investors were very disappointed, and the stock dropped 20%.

You can reduce a company’s risk by expanding your analysis of the company and the sector it belongs to before buying shares, but sometimes things happen differently than you expected. So you can’t be 100% right in all your investment ideas, and in a few investments, you will lose money. Unfortunately, it applies to everyone, including the most prominent investors.

However, if we have only one share and it has plummeted, we lose a lot of money, but if we hold, say, 20 different stores in equal amounts, and one of them has lost all of its value, we still only lost 5% of our entire portfolio of value. So, in other words, diversification is an excellent defence against the company’s risks.

However, how many stocks should we hold to be fully diversified?

As we have seen, too few shares increase the company’s risk, but on the other hand, too many claims will make it difficult to achieve profits that exceed the market.

Such a simple test can help us understand the correct number of stocks required for decent diversification:

• If you regularly buy all 500 stocks of the S&P500 index at the beginning of the year for many years and sell them at the end of the year, your average annual return will be about 10%, and the standard deviation will be about 20%. Statistically, it means that every 2 out of 3 years, your annual income will range from 20% higher (30%) to 20% lower (-10%) than the average income, or in other words – the US market’s volatility is 20%.

If you randomly choose one share instead of buying all 500 shares each time, your portfolio’s volatility will be almost 50%. It is more than double the market’s volatility and too high for most investors.

However, as the number of shares increases to 12-20, the volatility decreases sharply, only a few per cent higher than the market volatility. It means that buying 12 to 20 stocks will not make your portfolio any more protected from market volatility.

Indeed, when you look at the portfolios of successful investors like Warren Buffett and other gurus, you уusually see 8-15 stocks in their portfolio, which is the right way to diversify. On the contrary, mutual fund managers do the wrong thing, usually including more than 50 stocks in their funds, which reduces the portfolio’s volatility but does not allow them to “beat” the market. As a result, their net income after deducting management fees usually falls below market income.

To summarize, we note:

• if you are a novice investor without a lot of experience, it would be wise to include about 20 stocks in your portfolio, investing equal amounts of money in each share;
• The richer your experience and the more thorough your analysis, the fewer shares you need to hold (but probably at least 12 shares) and even invest more money in your best ideas;
• Buying 12 to 20 shares will allow you to make higher profits than the indices. However, buying several inefficient stocks will keep your stakes in different baskets and protect you from significant losses.

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