Quality Over Quantity

October 20, 2007 at 8:59 pm · Filed Under Educational 

You can’t do well without picking good stocks, but other small aspects of managing your portfolio can also have a big effect on your overall gains. Today we’ll look at how the number of stocks you hold can actually be the difference between being an average investor or a highly successful one. If you look to Warren Buffet and William O’Neil for guidance, two leading authorities on opposite ends of the spectrum, you’ll see that they actually agree on the matter, and both recommend focusing on a fewer number of high quality stocks.  Buffet has stated that the only reason Berkshire Hathaway has over 10 positions is because it’s just not possible to put the amount of money he has into fewer than 10 stocks.  O’Neil, more specifically, recommends that those with less than $20,000 keep a maximum of 3 stocks, those with under $100,000 in their portfolio should stick to 4 or 5 stocks, and those with less than $1 million should stick to 6 or 7 at the most.  To see the benefits, let’s look at an example of a portfolio with 5 stocks versus a portfolio with 50 stocks.

Profit & Loss Distribution

Total number of stocks 5 50
Stocks that made 100% 1 5
Stocks that made 20% 1 20
Stocks that broke even 1 20
Stocks that lost 10% 2 5
Portfolio % gain 20% 17%

I skewed the numbers towards the larger portfolio just to prove a point here.  Chances are, you’ll be able to put your money into one stock that goes up 100%, but you would be hard pressed to do it with 5 stocks while only picking 5 that you take a 10% loss on.  In the real world, you would probably see far more losers and far less 20% gainers, but in this example, the smaller portfolio still wins by a healthy amount; a 3% per year advantage ends up being 16% after 5 years and 81% after 20 years.  Notice that by splitting your money amongst 50 stocks, each 100% winner only increases your portfolio by 2%.  Even if you manage to hit a stock that gains 400% in a year, it would only gain 8% for your overall portfolio.  On the flip side, hitting a big one in the more focused portfolio would have a significant effect on your net worth.

That’s great, but what if I don’t get that single 100% winner?  At first, you might think it’s more likely to come down to luck if you have fewer positions, and we know that we don’t want luck to have a significant factor in our success.  This is where ego control comes into play though.  You have to be willing to take your losers and break-evens quickly so that you can move on to your winners.  In our example, 3 out of the 5 stocks were in the loser or break-even category.  When a stock doesn’t move the way you want, the most crucial thing you’re losing is time.  Theoretically, there’s no difference between holding 1 winner and 1 break-even stock at the end of the year and holding 1 winner and going through 100 break-even stocks (in reality, churning stocks would kill you with commissions, so you do need to find a balance). Another point to consider is with this added focus in fewer positions, you can concentrate your research more, so you’ll be more likely to have a higher percentage of winners in your portfolio.

What about diversification? The point of diversification is to limit risk exposure, and the number of stocks in a portfolio shouldn’t be confused with having a diversified portfolio. It’s possible not to be diversified at all, even if you’re holding 100 stocks, if they’re all from the same sector, e.g., the top 100 dot coms, which will all go down together in the event of a tech bust.   Normally, if the economy is going down, the majority of the stocks are going down too, so having more stocks in your portfolio makes it even harder to have a high percentage of those abnormal ones that are bucking the trend.  By holding several stocks, with each in a completely different sector, you can defend against losing all your money due to a specific weakness in one area if that’s the kind of diversification you’re looking for.  True diversification, however, comes from holding other investments that aren’t correlated, like foreign stocks, bonds, real estate, etc.

Hopefully, I (or Buffet and O’Neil, if you don’t care about what I think) have convinced you to keep a smaller, more streamlined group of only top-quality positions.  As long as you set good cut off points to reduce the risk of a single stock undermining your whole portfolio, you’ll find it much simpler and more rewarding in the long run.


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