To achieve high returns from a well diversified portfolio, shall I invest in lot of stocks to find some multibaggers or shall I restrict to fewer stocks. We are sure this question must have come to your mind when you started investment in equities. In the famous report published by J. Evans and S.H. Archer in 1968, they advised to have 20 to 30 stocks. While a recent study released in 2014 by Vitali Alexeev and Francis Tapon, advises 90 to 110 stocks. There are no right or wrong answers and researchers are divided between 20 stocks to 200 stocks. We at AI, believe that it entirely depends upon your investment style & preference but even then, there are certain rules to follow. Let’s find out in detail. Portfolios are constructed to achieve diversification i.e. invest in stocks across sectors to minimize risk. Based on investment style, you can classify investors into two broad categories.
First category of investors are people who invest in lot of stocks believing that investment into large number of stocks is necessary to hit one multibagger. To an extent this is true as well since multibaggers are hidden small caps which are not known with certainty at the time of purchase, so it becomes akin to gold mining where you process chunks of mud to pick out tiny gold pieces. However, often this approach does not work since a few multibaggers are not able to make significant difference to their whole portfolio. Imagine if someone invests 10 thousands in 100 stocks, even if one stock becomes a multibagger and gives 20x return, his rest 99 stocks will drag overall returns. It must be kept in mind that overall return is a calculation of weighted average. Ideally you should have more money invested into multibaggers & lesser money into poor stocks. This can be achieved by investing only a probing amount first and putting more money only when stocks perform. It does not matter how much a company’s future looks promising, always invest based on real performance & not paper performance. Earlier we have written a post how to invest in phases, we highly recommend you read it if you invest in lot of stocks, click here to read in a new window.
Second type of investors invest in lesser number of stocks and put a focused approach to garner high returns. The main difference is that these investors unlike the first one, prefer to invest within their portfolio limits. If in process they get multibaggers, nothing like it, their portfolio will shine but if not, they are fine with little less than multibagger returns as well. You will be surprised to know that in many cases, second investor will beat first invest over longer period of time. Various studies conducted in the field of behavioral economics proves that focused approach often (not always) works better in long term but it is not as exciting as the first investment style. This reminds me the story of a tortoise and a rabbit, where tortoise wins the race. However, focused investor has risk of limited diversification & missing multibaggers.
What about number of stocks? For focused investment style, we believe one should not have more than 20 stocks in his portfolio since beyond that diversification will not decrease overall portfolio risk. The graph below shows risk in terms of standard deviation vs number of stocks help. It was first published in 1970 by Lawrence Fisher and James H. Lorie in the Journal of Business. We can see that beyond 10 stocks, the portfolio risk starts to become flatter & somewhere between 10 to 20 stocks the portfolio risk almost stops reducing.
Why do Mutual Funds have 90-100 stocks? We must stop looking and mimicking mutual funds portfolio with our own portfolio because they are not similar. We are comparing apples with oranges. Mutual funds are a pooled investment, they have to keep lot of stocks to manage redemption pressure, keep high level of correlation with their benchmark which is usually some index. Also they must have a number of stocks to be able to invest at any given point in time. This is even more important when fresh money is pouring in like these days and many stocks are already costly. All these conditions do not apply to an individual. You can very well have a portfolio with lesser stocks and still achieve good diversification.
So what is the best approach? According to us, it should be the blend of both. You can divide your money into two buckets in the ratio of 40:60 (60% in favor of focused approach). Invest both portions keeping in mind your weight in each stock. Remember, overall return is the calculation of weighted average. So for first approach, always start with a probing amount & increase your money into performing stocks. In focused approach, investment in phases is not mandatory since you will be investing in a pre-defined ratio, so overall exposure will remain constant. This is exactly what we have in our services, Tiny CAPS (TC) & MultiCAP Multibagger (MM). While TC is aligned to first investment style, MM is suited for second investment style. If you are not sure how to execute these approaches, subscribe to our TC & MM services which are professionally managed with these features in mind.
AI post is a free service which will remain free to our readers. If you like this article, please share using buttons at the bottom of this page.