You invest in stocks to meet your financial goals; earning high returns helps you achieve them faster.
But you need to remember that your goal is the ‘dog’, and high returns are the ‘tail’. And as the saying goes, you must not let the tail wag the dog.
Far too often people forget this, and chase higher returns without paying heed to risks. Investors get excited when presented with unique and high potential investment idea. They go overboard without analysing, ‘How much I lose when I am wrong?’
Investing is all about the future, and the future is always uncertain. This means you are always exposed to risk. You cannot eliminate risk, but you can and must manage it.
How do you manage risk in investing?
Discipline and Diversification are two effective tools that help you do this. Unfortunately, investor often get carried away with current sentiment.
Discipline prevents you from letting your emotions drive your investment decisions.
We see investor get overconfident when few stock ideas work well in good market and tend to go overboard in new investment idea. This pinches them hard when the tide turns. Reverse behaviour happens in bad market when a couple of bad spells leads to loss of confidence. This makes investors overdiversify to own as many as 100 stocks.
Ideally, an investor must be indifferent to individual stocks and focus on improving long term process to avoid disappointments. This does not mean that it will work wonders all the time, but following the process consistently is essential to sail through long term game called investing, and also to earn high returns.
Diversification is the only free lunch which makes investment journey pleasant and profitable
Statisticians have studied the volatility of a portfolio with varying number of stocks from 2 to 500 versus the market. They concluded that volatility reduces to a large extent, when a portfolio has 16 stocks, and having more than 32 stocks doesn’t materially reduce the volatility any further. So, we believe the investor must hold somewhere in the range of 16-32 stocks to get the maximum possible benefit of diversification.
No wonder, most popular Indices like Dow or Sensex also own just 30 stocks and they capture overall market movement perfectly.
Should stocks be bought equally in a portfolio?
Not all stocks that make the final shortlist are equally robust. So there is no reason to hold all business equally.
Few stocks deserve higher allocation than others, especially the ones with a strong and consistent performance capability, the ones with a strong sustainable moat.
Cyclical sector stock or average quality company deserves moderate allocation.
MoneyWorks4me’s Stock Allocation Strategy:
As established by statistics that adding more than 32 stocks doesn’t add to diversification, that becomes our upper limit. 1/32 stocks means, no stock should be less than 3%.
Minimum 16 stocks for diversification benefits means no stock should be more than 6-7%.
We recommend 5-7% of portfolio weightage to good quality and sustainable growth companies. On the other hand, stocks of companies that are slightly cyclical, small size, single product/single geography or client concentration or asset-based business fall in the 3% bucket.
Using this allocation strategy, the volatility of your portfolio is likely to be lower or similar to the market, as your portfolio is skewed towards stable businesses, and volatile companies are a smaller portion of the portfolio.
Depending on how many stocks in each bucket come in our BUY zone, most of our client portfolios have 20-25 stocks. We believe that is a reasonable number of stocks one must own.
Why can’t we own concentrated portfolio of just 5-8 best ideas?
We don’t know in advance which 5-8 ideas are the best. Los Angeles-based large money manager Capital Group experimented with a “best ideas” fund based on the single highest conviction stock picks of their portfolio managers, it flopped. And flopped again.
While Capital Group’s system of dividing its analysts into teams and merging them into a single fund continued to work, its “best ideas” fund lagged the benchmark.
This happened because the highest conviction comes not from the investment merits but amount of time spent on a particular idea. Sounds familiar? Yes, we overestimate we know everything that is there to know about a company. But future is not in our control.
There is another study which favours diversified portfolio approach.
“A finance professor made a startling discovery about the stock market: Over a 90-year span, 96% of all stocks collectively performed no better than risk-free 1-month Treasury bills. After analyzing the lifetime returns of 25,967 common stocks, Hendrik Bessembinder determined that just 1,092 of those stocks — or about 4% of the total — generated all of the $34.8 trillion in wealth created for shareholders by the stock market between July 1926 and December 2016. Even more striking, a mere 50 stocks accounted for well over one-third (39.3%) of that amount.” (Source: Kiplinger.com)
A similar study by Motilal Oswal in India found, “Over 1995 to 2020, the Sensex rose from 3,200 levels in March 1995 to 29,500 by March 2020 i.e. a CAGR of 9.2%. Interestingly, exactly 100 companies delivered returns higher than 9.2%.” This means just 20% stocks deliver index beating returns.
To conclude, there are just handful of stocks in the market that create huge wealth. By owning just 5-8 stocks, you run a risk that these may not be one that will create disproportionate wealth. By casting the net wide, you improve your odds to own few big winners of future.
All in all, at MoneyWorks4me we look to strike a right balance between aggression and conservatism. We do not recommend spreading out capital into 100s of mediocre ideas nor owning very few stocks running a risk of missing out on large winners.
In investing, you are always exposed to risk whether it materializes or not. If you invest for a reasonable time, you will encounter risk, and how you react to it will determine whether you will meet your goals.Read our blog posts on Risks at the Portfolio-level and Risks at the Stock-level to know more.
If you have an existing Stocks portfolio, you can identify risks in your portfolio real time, and get recommended actions to reduce them, with our Portfolio Manager, for free! Just register and upload your portfolio.
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Very valuable article!!! Thanks for sharing.