A question I frequently get from readers and subscribers is what percentage of their portfolio should they allocate to each trade. While only a licensed investment advisor can give a specific answer after conducting a thorough interview with each investor, I will share some of the basic concepts involved in making this decision.
Most people are familiar with the saying, “don’t put all your eggs in one basket”. If you drop that basket, then you lose all of your eggs. The same principle applies to the stock market. There are plenty of unknowns in this world and any one of them could trigger a debilitating blow to your account if all of your money was concentrated in a single stock. A management scandal or shockingly bad earnings report could devastate your savings overnight.
If you only owned a single stock and it fell 50%, then you just lost half of your savings in one blow. And worse, to recover from that 50% loss you need a 100% gain just to breakeven. In the best of times it takes multiple years to double your money. But if you were diversified and owned 10 stocks in equal amounts, if one of them fell 50%, then you only lost 5% of your total account value. It only takes one or two good trades to bounce back from a 5% loss.
I won’t get into the statistics involved, but an account will be nearly perfectly diversified if it has between 20 and 40 independent securities, with independent being the key word. Independent means each stock is not correlated to the others in any significant way. A beverage maker, toy company, and airline are in much different industries and are largely independent from each other. On the other hand, five 3D printing companies, five airlines, or five tech companies are most definitely not independent. These companies are highly correlated because often what affects one company will affect all the others in the same industry. For example all airlines would be hurt if there was a sharp rise in oil prices.
Owning more than 40 stocks moves into the realm of diminishing returns and does almost nothing to improve diversification. All it does is add expenses and complexity to your portfolio. At this point you are better off buying an index fund and forgetting about it.
While 20 stocks provides us with nearly full diversification, there is also a cost to being diversified. If we have five stocks and one of them doubles, our account value jumps 20%. But if one of twenty stocks doubles, that is just a 5% gain. And if one of 40 stocks doubles, we only made 2.5% from that great trade. So while diversification protects us from the unknown, over-diversification diminishes our returns because our best trades get watered down.
The other issue with investing in too many stocks is each of us only have so many good ideas. Most of us can come up with three or five great trades a year. But how many of us can come up with 20 great trades? Most likely we will have three great ideas, five good ideas, and maybe eight decent ideas. The deeper we reach, the less potential each additional idea has. Most of the time we are better off-putting more money into our best ideas than investing in mediocre ideas just for the sake of diversification.
The goal for the savvy trader is finding the right balance between prudent diversification and watering down. For most investors this falls between four and eight stocks at any given time. Fewer than four and one mistake can prove costly. More than eight and the gains become too watered down. Account size is also a factor. If a person only has $10k to invest, they are better off on the lower end of the range. If a person is trading $100k, they have the resources to spread across more trades.
Almost every single traders would be better off if they held at least four stocks, but no more than eight stocks in their trading account. Putting too much of your savings in one or two stocks leaves you vulnerable to the unknown. Investing in more than eight stocks means some of your ideas are not very good and you should cut those out and add that money to your better ideas.
The above focuses on individual stocks in a trading account. The situation is different if a person is trading an index fund that is already providing a good level of diversification. Other strategies apply when deciding how much money to put in an active trading account, versus how much a prudent investor leaves in buy-and-hold investments. These are equally valuable topics I will cover in a future CMU post. Be sure to sign up for Free Email Alerts so you don’t miss those useful posts.
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Jani Ziedins (pronounced Ya-nee) is a full-time investor and writer who has successfully traded stocks and options for more than a decade. He earned a B.S. in Mechanical Engineering from the Colorado School of Mines and an MBA and M.S. Marketing from the University of Colorado Denver. His prior professional experience includes manufacturing engineering at Fortune 500 companies, structural engineering, small business consultant, collegiate instructor, and managing investment real estate. He is now fortunate enough to trade full-time from home, affording him the luxury of spending extra time with his wife and two young children.