How many stocks to own? kcchongnz

Recently I have read someone commented that 99.5% of the companies listed in Bursa are rubbish. With 914 companies listed in Bursa Malaysia as of to-date, that means only 4 or 5 companies are investible. The author’s action is true to his words.

Another commentator mentioned that there are only about 20 companies listed in Bursa which are investible. But this person also advocate focus portfolio, may be less than 10 stocks.

The above investors are focus investor having concentrated portfolio of stocks which they perceived as great companies which they have deep knowledge about and to be held for long-term. They are the followers of Warren Buffett style of investing. They just have a few eggs and they make sure they remain good eggs and watch them very closely.

Warren Buffett

For the 50-year period from 1965 to 2017, the compounded annual growth rate (CAGR) of Berkshire Hathaway’s share price was 21%, translating into a total gain of over two million percent. This beats the CAGR of about 10% of the S&P500 by a wide margin.

A $10,000 investment in Berkshire Hathaway stock in 1965 would be worth $240 million as of the end of 2017.

Buffett is interested in analyzing stocks qualitatively. He felt he could gain an edge by doing more in- depth research. He visited companies, he talked to management, and he considered the actual prospects of the business. He basically believed that using both quantitative and qualitative analysis was better than just using one or the other.

There was another famous and successful growth investor, Philip Fisher of the “Common Stocks & Uncommon Profit” fame, whom Buffett follows closely in his philosophy of deep-qualitative analysis.

Who dare to say Warren Buffet’s style of active and concentrated investing is wrong?

It’s a fascinating topic to think about, especially for mere mortals (like most of us), who don’t possess the genius that Buffett has in analyzing business. Walter Schloss (will introduce later) said it best about Buffett:

“Warren is brilliant. There is nobody that has ever been like him, and there never will be anybody like him. We cannot be like him”.

Water Schloss

“The only investors who shouldn’t diversify are those who are right 100% of the time.”

Sir John Templeton

There was another disciple of the Grand Master of value investing Benjamin Graham, Walter Schloss. Few knows who Walter Schloss is.

He is another very influential investors having the same record-breaking 21% CAGR over a 50-year period from 1955 to 2010, three times the 7% return of the S&P during the same period. 

Unlike Warren Buffett, Schloss bought a lot of stocks and hold them in his portfolio. The stocks he bought were cheap stocks, typically Graham type of stocks, cheap in relative to asset value, and hold them for a few years and realized his profit. He often owned 60 stocks or more at a time, sometimes as many as 100.  He claimed he was not a good judge of business trends or management capability (as opposed to Warren Buffett). He repeatedly said “I don’t like losing money”. So, he needed to take a diversified approach so he could “sleep well”.

“I like the idea of owning a number of stocks. Warren Buffet is happy owning a few stocks, and he is right if he is Warren….”

Buffett, instead of ridiculing him of buying “rubbish”, detailing his exemplified records of success, and praised him very highly in his famous speech, “The super investors of Graham and Dodd” in the Columbia School of Business some years ago.

Peter Lynch

Peter Lynch’s spot in the list of greatest investors stems in large part from his work with the Fidelity Magellan Fund between 1977 and 1990. During this 13-year period, the fund posted a CAGR of 29%, beating the S&P 500 index in 11 out of 13 years and building the fund’s assets from $20 million to $14 billion. The fund had the best 20-year return rate of any mutual fund in history.

A $10,000 investment that earned this return for 13 years would have grown to nearly $280,000.

Peter Lynch's performance at the Magellan Fund is even more impressive when you consider the sheer number of stocks the fund owned. In fact, the Magellan Fund had more than 1,000 individual stock positions at times, eve up to 1400 stocks.

Lynch believed strongly in diversification, or spreading your investment dollars around, in terms of industries, company size, and growth potential. He just bought more and more stocks if he found them good stocks and selling at good prices.

However, Lynch doesn't believe in diversification just for the sake of reducing risk. Lynch refers to this as "diworseification." Lynch's goal was to build a portfolio that was diversified, but was also full of good stocks at all times.

Imagine if he were to analyse each stock in great details, visiting the companies and management often.

Joel Greenblatt

Joel Greenblatt is my favorite super investor who popularized the “Magic Formula” Investing strategy. He is an American academic, hedge fund manager, investor, and writer. He is a value investor, and adjunct professor at the Columbia University Graduate School of Business.

In 1985, Greenblatt started a hedge fund, Gotham Capital, with $7 million. Through his firm Gotham Capital, Greenblatt presided over an impressive CAGR of 30% over a period of 20 years from 1985 to 2006. The $7 million capital turned into $1.7 billion 21 years later.

Joel bought a portfolio of about 30 stocks using his magic formula of high return on invested capital, ROIC and earnings yields at the firm level to identify good companies selling at cheap price, and rebalancing the portfolio annually. He basically follows the purely quantitative approach in doing so.

So, can we tell Walter Schloss, Peter Lynch, Joel Greenblatt that they are stupid idiots, and ridicule them for holding so many stocks?

But how many stocks should an individual investor hold?

Academic Approach

Many academicians believe there is a kind of free lunch in the market, i.e. in portfolio diversification. In academic, risk is measured by the standard deviation of return, the higher the variance, the riskier is the portfolio. So, to reduce risk, more stocks are included in the portfolio.

As the number of stocks in the portfolio increases, the variation of return reduces sharply initially as shown in Figure 1 below. Studies and mathematical models have shown that maintaining a well-diversified portfolio of about 20 stocks will yield the most cost-effective level of risk reduction as shown in the figure below, beyond that, there is negligible additional benefit for adding more stocks.

Figure 1: Reduction of idiosyncratic risk

Stocks diversification won’t ensure gains or guarantee against losses but strives to smooth out unsystematic risks of companies in a portfolio which are not perfectly correlated so that the positive performance of some companies will neutralize the negative performance of others.

In Practice

The popular adage of "Don't put all your eggs in one basket" is very much suited for investing in the stock market. It advocates diversification, a technique that reduces risk by allocating investments in a number of stocks in the portfolio. Ideally the stocks chosen should be spread over different industries that would each react differently to the same event.

In practice, the decision about how many stocks to own is the balance between risk and return. The more concentrated your holdings, the greater the chances of exceptional returns if you are in the right stocks, but there is also a higher risk of a substantial decline if you stock picking is poor.

Another factor is your tolerance for volatility. If you are heavily concentrated in just a few fast-moving names or small-caps issues, it won't be uncommon to have swings of 5% on a daily basis. Many retail investors cannot handle that sort of movement and probably lose sleep at night.

Time frames also influence the number of stocks you hold. Some traders take the approach of high concentration for short periods of time. They can handle the lack of diversification because they are willing to move quickly at the first sign of trouble.

Another factor that will influence how many stocks you own is the amount of capital with which you are working. If it a very small account, it isn't possible to be highly diversified because of the high costs of transaction. On the other hand, there are large funds that will hold many hundreds of stocks because there isn't any other way to put their capital to work.

My take as a guide,

Less than RM100k capital: 5 stocks

RM500k: 10 stocks

RM1m: 15-20 stocks

More than RM10m: more than 30 stocks

Having more, but not too many more, carefully selected good stocks, besides avoiding huge losses, also has a higher chance of striking some multi-baggers which could increase the return of the portfolio tremendously.

Happy investing