When building a portfolio, investors want to find the sweet spot between risk vs reward. Balancing this risk is not easy however, especially since investors’ attitude towards risk are not homogeneous – in general however we assume that for every unit of risk we take on, we expect to be compensated for this in an ever compounding amount. When compiling a portfolio, common sense does dictate that you should not put all your money into a single stock, diversifying your holdings does decrease risk. We want to look at the optimal level between having fully diversified portfolio, and not having too many stocks to be able to manage them efficiently. how many stocks should I have in my portfolio?
This article will get technical, as we are dealing with concepts developed in modern portfolio theory (there is a great intro into MPT on Investpedia here). As with most academically developed concepts, there are vast amounts of MPT which although make attractive looking formulas, mean that the theory does not always hold sway when released into the wild. There are just too many macro and micro variables which can affect the overall risk of your portfolio (unfortunately no one has developed a formula to measure the risk of a company annoying Trump and having him tweet about them yet). How Many Stocks Should I Have In My Portfolio?
Risk in itself is relatively straightforward concept to understand. Investor have the option of purchasing “risk free” assets, such as 10 year government bonds (although not strictly risk free, the likelihood of a developed nation defaulting on bond payments is so low that it they are considered to be risk free) how many stocks should I have in my portfolio?
This table shows the current global risk free rates. As you can see, particularly after tax, the yields are not great. To increase our expected returns, we need to look for companies who offer better potential returns in the form of either capital gains, or income from dividends. how many stocks should I have in my portfolio?
Applying the yield filter on our Terminal returns 630 companies who are paying a 5% yield and above at their current share price.
Unlike a government bond, this does not guarantee that the company will distribute a +5% yield when it comes to paying their dividend – there is additional risk involved that they wont. We can mitigate this somewhat by looking at the dividend history – if for the past 5 years it the yield has hovered around the 5% mark, then there is a strong possibility that it will remain at the that level, for example.
Now according to the MPT, there are 2 types if risk. Systematic and unsystematic.
Systematic risk is related to market risk, and this cannot be diversified away. An example would be if there is a nuclear war, or an earthquake. This is the inherent market risk, or market segment risk. This is one issue with an index linked ETF. When Brexit referendum passed, the whole of the UK stock market was effected regardless of whether you had 1 or 1,000 stocks in your portfolio (assuming it was made up of UK stocks).
What we are interested in is unsystematic risk. The underlying idea is that by owning stocks in different companies and in different industries, as well as by owning other types of securities such as Treasuries and municipal securities, investors will be less affected by an event or decision that has a strong impact on one company, industry or investment type.
This is one of the arguments, aside from low management fees, of investing in ETFs. You get great diversification. But you also get the good stocks along with the bad stocks, and we want to fill our portfolio with market beating stocks.
Picking a portfolio with 500 stocks in it is not realistic however. So how many do we actually need?
You may be surprised to find out that a portfolio with 12-18 stocks achieves 90% of the maximum diversification possible. At 30 stocks, you are an par with an ETF in terms of unsystematic risk reduction.
So if you are worried about not being diversified enough, a portfolio with 12-30 (or whatever you are comfortable with) stocks is enough to significantly reduce all unsystematic risk.