This is a common dilemma faced by an investor. Read to find out what suits you.
26-Jul-2022 •Karthik Anand Vijay
How many stocks should you have in your portfolio? That's the first decision you will have to take while building your portfolio. The investing world has fancy names for this decision: do you build a concentrated portfolio or a diversified portfolio?
Having a few stocks mean you have a concentrated portfolio, while many stocks mean you build a diversified portfolio.
Some of the world's most successful investors, including Warren Buffett, Charlie Munger and Philip Fisher, have followed the concentrated investing strategy.
A concentrated portfolio has around 10-15 high-quality companies and produces above-average long-term returns. This happens because you place relatively larger investments in a smaller number of stocks. The success of even a handful is thus magnified, giving your portfolio oversized gains.
This strategy has an equally risky flip side. Make a mistake and you could lose a large part of your portfolio. So, you need to invest in companies that you understand well. You also need to develop the mental fortitude to hold stocks over the long term and not get rattled by market volatility, like the one we are seeing today.
A way to build a concentrated portfolio with less risk is to diversify the smaller number of companies across different sectors.
You have an easy alternative if you don't want the risk of a concentrated portfolio. Build a diversified portfolio. By increasing the number of companies you own, you spread your risk so that few companies don't account for a large share of your portfolio.
This makes sure that when you make a mistake (which almost everyone does), you don't get burned. Here, the number of companies can easily exceed 30. Some of the successful practitioners of this approach include Benjamin Graham, Walter Schloss and Peter Lynch.
With diversification, the poor performance of a few companies doesn't hurt you as much as that in a concentrated portfolio. But you don't get to benefit from the winners to the same extent either. But that doesn't mean that you are safe. When the market crumbles, your portfolio will too!
A consequence of diversification is that you might end up investing in a company that you don't fully understand. Besides, you need to track all the companies in the portfolio and all of a sudden it seems like a hectic chore.
If you are not a very sophisticated investor or don't want to risk your money on just a handful of bets, then this is the way to go.
Both approaches have seen success under various investors. You have to decide which approach is more suitable for you. If either approach seems extreme, then you can consider the middle ground, i.e., neither too concentrated nor too diversified. This would mean a portfolio of around 20-25 companies.