Besides the constant contemplation over the stocks I hold within my portfolios, the perennial question I ask myself as an investor is how many stocks should I own?
After investing for years I have heard many opinions from both academics and investment professionals as to the number of stocks you should own. It is generally accepted that risk is reduced as the number of investments is increased — as per modern portfolio theory. However, there is debate over the particular number of holdings that are optimal for diversification.
You often hear the golden number of 15-20 holdings, as studies from Evans and Archer (1968) and Elton and Gruber (1977) alluded to this being the minimum requirement needed for diversification of risk. Many private investors have stuck to this as it has percolated through the studies of asset managers and into private investor reading material and in the work of popular investment writers. But, going back to the source, I believe there is a key piece of information investors are missing by investing in 15-20 stocks in the effort to minimally diversify. The studies that diversification theory was based on typically looked at the standard deviation of equities when choosing a number of stocks on a random basis — literally rolling a dice and choosing stocks out of the S&P500 index. Thus, in my opinion, I see a risk to investors who are investing in 15-20 stocks, as I would argue that their choice of stocks is very rarely completely random and therefore they are typically overweight to specific sectors or themes. I would go a long way to argue that if you stick to a specific geography, sector or company size for your investments, even if you own more than 20 stocks, you probably aren’t diversifying your risk.
So, understanding that we need to have a diverse basket of sectors, company sizes and geographies, how many stocks should I then hold?
Well, there really isn’t a perfect answer to this question, but I recently read something that I think expertly sums up my approach to finding a solution to portfolio structure.
Octopus Megayacht — Commissioned for Microsoft Co-Founder Paul Allen
Jonathan Barnett, a yacht designer based in Seattle, has been drawing and building superyachts since the late 1980s. Barnett was the designer for Octopus, the $250m megayacht pictured above, which is one of the world’s biggest and best-known superyachts.
When Barnett initially sits down with a blank sheet of paper to design a yacht, he tells clients that size is the wrong place to start. “The scale of a vessel is entirely based upon its purpose,” he says. A decision on the size of the yacht sits at the very end of what he calls 'the design spiral' – a list of increasingly detailed questions about what the purpose of the yacht and what it is supposed to achieve. (Source FT)
To me, this style of thinking seems a great way to think about a portfolio. By asking some critical questions about the purpose of our portfolio and what it is supposed to achieve, we can start to think about portfolio construction from a holistic perspective, which will be suitable for a long term investment journey, or voyage so to speak. It is when we begin to delve into the purpose of a portfolio that we can begin to understand the needs as to the number of holdings.
Critical questions may be:
How long will I remain invested for?
Do I need access to the capital and when will I need access?
What is the purpose of my investments?
How much risk am I willing to tolerate?
What is the total value of my portfolio?
Concentrated portfolios of 15 - 20 stocks work very well if the overarching portfolio theme is performing during a particular market cycle. However, volatility is inherent in markets — some sectors or even market geographies can suffer from years of underperformance (Brexit anyone?).
Another theory, which is perpetuated by the investment managers at Baillie Gifford, is one coined by Hendrik Bessembinder, a professor at Arizona state university, who published a paper in 2017 that looked at the 26,000 companies listed in the years 1926 to 2016. Bessembinder found that 4/7 common stocks listed during that time frame lost money compared to US treasury bills (government bonds) and that, rather shockingly, the best 4% of stocks created the total gain in the US stock market over the 90-year period. This theory underpins the idea that gains in the stock market are increasingly had by large ‘winner takes all’ style events, and that missing allocation to the specific 4% big winners often leaves us underperforming versus an index.
By opting for a longer list of investments, I personally plan to both decrease my stock-specific risk and increase my odds of holding on to the 4% of companies that deliver outsized returns over time.
Taking a look at my individual portfolios, my purpose for the Personal Portfolio is to compound my wealth at a mid-teens rate over the long term. This portfolio isn't required to provide me with any short term liquidity or a house deposit, and thus my risk tolerance is quite high and my expectations for growth are too. I intend to grow wealth by holding 25-35 companies that I believe are good quality, have competitive edges and can grow revenues sustainably.
Percentage Breakdown of Holdings in my Personal Portfolio
The quest for growth naturally takes you to shares in the technology sector and its proverbial cousin, the payments sector. The Personal Portfolio also has a much higher weighting to consumer discretionary companies such as Games Workshop or Peloton. Both of these companies sell products that we don’t really need in times of economic hardship, but their businesses are currently seeing great levels of growth. Retail is a similar sector and one that can increase volatility in the portfolio significantly. Shares such as Boohoo can grow at high levels over the long term but are known for drawdowns of 30% on bad events. When it comes to the Personal Portfolio, this tolerance for drawdown is accepted in line with the portfolio's purpose.
Company Size Profile in $ Billion in the Personal Portfolio
The Personal Portfolio is also increasingly weighted to smaller companies, with over 40% of the holdings allocated to businesses with market capitalisations less than $10 billion (GBP market caps have been converted to USD). This smaller weighting is also in line with the portfolio's core purpose as a portfolio with a very long term horizon. By investing in a higher number of smaller companies, I can hopefully catch some of that growth as they grow into larger entities over time, allowing for an enlarged growth prospect for the overall portfolio.
Contrast this with the Family Portfolio, which was created by myself to manage the majority of my family’s savings. This portfolio has a completely different purpose. The purpose here is to sustainably grow the total capital in a lower risk format. Some of the capital may one day be needed by a family member for retirement drawdown or for the purpose of life events such as moving home or medical complications. For these reasons, I need to be sure we can have access to this cash in any environment, and that the capital is spread over a diverse basket of companies. For the Family Portfolio, quality matters above all else. Companies must have strong business models, cash returns and good management in order to be suitable for the portfolio.
I have 60 holdings for the portfolio, which is way above the ‘sweet spot’ suggested by commentators of 20-30 holdings, but this is what I feel comfortable with given the purpose outlined above.
Percentage Breakdown of Holdings in my Family Portfolio
Here, I have made cornerstone investments in consumer staples and healthcare businesses, companies like Unilever and Clorox in staples and Stryker in medical devices. These businesses tend to see very consistent levels of demand regardless of their economic environment, but they also experience solid levels of growth too. Technology still has a high weighting, mostly as I truly believe some of the best companies on earth operate in this sector. I also think the market underestimates the ‘stickiness’ or unavoidable use of services that companies such as Adobe Systems or Alphabet provide to name a few. The weighting to businesses more discretionary in nature is lower for this portfolio, as I want to ensure a less cyclical performance in line with the purpose statement. A 13% exposure to industrials also may sound like the introduction of cyclicality, however, looking at this segment on an individual basis, I have been careful to choose companies that service an installed base of equipment, thereby reducing overall volatility.
Company Size Profile in $ Billion in the Family Portfolio
Naturally, in line with the portfolio’s purpose, I have exposed the Family Portfolio to a higher number of large-cap companies. 33% of the portfolio is invested in companies over $100 billion in market cap, with 25% in the $25-100 billion range. The mere size of a company does not necessarily make an investment safer — many large companies fall from grace. However, successful companies with proven business models and resilient levels of growth don’t tend to stay small for too long. But the one thing a large size does grant you as a small investor is the ability to move your money in and out of companies with ease and little spread variance (the price between buy and sell). In the event of panic in small-cap companies, holdings can sometimes be difficult to sell, and the addition of fear can create large drops in share prices. Having said this, there is potentially a risk involved in owning mega-cap companies above $500 billion, given the possibility for regulators to break up business into smaller entities. Thus, a balanced portfolio in terms of company sizing also helps.
Family Portfolio Geographical Breakdown
Lastly, looking at the Family Portfolio from a geographic perspective allows for the understanding of risk from a regional perspective. A first question may arise from the overweightedness to companies in the US, which isn’t my home geography being a private investor in the UK. My simple answer to this is that the best businesses are typically found in the US. The country is home to a set of very high-quality companies, it possesses a highly capitalistic market structure that typically looks to benefit shareholders in society and its incredible size as a market often means companies can continue to grow in their home market before needing to expand internationally (which increases risk). Regardless of this, the US also makes up roughly 66% of the MSCI world index, thus, this portfolio is comparatively underweight compared to the world’s market structure. Being an investor from the UK, I am naturally attracted to British companies and am able to follow their stories with greater accuracy, thus the UK also has a high weighting. The remaining 20% is equally divided between companies in other developed countries.
I hope this has not only given some insight into my own portfolios, but how you can use a clear purpose to define what a portfolio should look like for you, and provide some guidance as to the questions you must ask yourself and what your concluding actions for your own portfolio may be.
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