How Many Stocks Should You Own?

Financial advisors often insist that you should diversify your stock portfolio (i.e. own multiple stocks) to reduce your risk. After all, if you bet 100% of your portfolio on a single company that goes bust, you’ve lost 100% of your investment. The logical solution is therefore to own several stocks. So the more stocks you own, the less risk you should have, right? 

It’s not quite that simple. Legendary money manager Warren Buffett does not recommend too much diversification and suggests owning only a handful of stocks. He once quipped: “Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.”

Opposite concepts
There are two opposite concepts for choosing how many stocks you should own.

One theory says that you should diversify. The idea is that when some stocks go up, others go down. So you could buy different sectors: tech, pharma, utilities, consumables or defense. Or buy different company sizes: large cap, mid cap and small cap. Or buy stocks from different regions: United States, Asia, Europe, emerging markets, Latin America, etc. If you truly embrace this concept, you may end up buying 100 or more stocks, just like a mutual fund. Yet, are you a fund manager?

Tracking over 100 stocks takes a lot of time. Actually, it’s a full-time job. That’s presumably time you don’t have. In addition, owning so many stocks will dilute your returns. Even if one goes up 500%, it barely will affect your total return. So you might as well buy a diversified mutual fund and simplify your life.

Another theory says that you should buy just a few stocks. This is called a “concentrated” portfolio. You should only own 10, 15 or 20 positions. If you’re right, you will win big. However, if you’re wrong, you will lose a lot.

This is what the best professional investors do. You may have heard that a brilliant investor, mutual fund manager, or hedge fund manager invested $1 million in a stock that tripled. But you also may have heard of managers who invested $1 million in a company that tanked. Ouch. They can afford such a gigantic loss (after all, it’s not their money!). You probably cannot.

So, what are you supposed to do?
You need to compromise and find a happy solution between the two extremes.

One way to lower your risk is to never invest more than 4% of your total portfolio in a particular stock. If you use a 25% trailing stop, that means that you cannot lose more than 1% of your total stock portfolio.

Confused? Let’s take an example. Say you have a total stock portfolio worth $10,000.

If you invest no more than 4% in a particular company, it means that you cannot invest more than $400 in a single position (4% of $10,000 is $400).

We’re not suggesting that it’s a smart idea to invest $400 in an individual stock; this is simply an example. It also means that you will not own more than 25 stocks (25 x $400 = $10,000).

If one particular stock loses 25%, you must sell according to your trailing stop strategy. This means that you will not lose more than $100 on a particular stock (25% of $400 is $100). This also means that you cannot lose more than 1% of your total stock portfolio ($100 of $10,000 = 1%).

There is nothing magical about 4%, but there are several benefits to this strategy:

• It’s a compromise to manage risk, while allowing you to have a portfolio that is not too concentrated.
• It’s simple to understand and simple to calculate.
• It reduces your trading fees. Buying fewer stock means paying fewer commissions — assuming you don’t buy and sell every other day.

If you limit each stock purchase to 4% of your portfolio, you will manage risk, reach diversification and sleep better.

Phil Zeltzman, DVM, DACVS
Meredith Jones, DVM
Co-Founders of Veterinary Financial Summit