Warren Buffett: How Many Stocks Should You Have In Your Portfolio?
While investing in the stock market can be lucrative, it can also be overwhelming and risky.
One of the biggest questions for investors is the number of stocks they should own in their portfolio.
This question has become a riddle that has remained unsolved by many investors for centuries.
Fortunately, Warren Buffett had come to save the day for investors by proffering an answer to this age-old question.
What is Warren Buffett's view on this question? Stick around to find out.
Diversification
The word diversification sounds profitable in every aspect, investing inclusive. It means putting only some of one's eggs in a basket.
Diversification is the way of getting the most out of the stock market.
Since you didn't put all your investment in one or two businesses, you won't be wrecked by volatility when it happens. You will also be able to sleep peacefully at night.
According to Warren Buffett, this analysis sounds attractive, but there are other answers than diversification when it comes to the number of stocks to invest in.
Diversification is like a protection against ignorance, and it makes little sense when you know what you are doing.
He is arguably one of the most successful investors of all time, and currently the fifth richest person in the world, all thanks to his business tactics. So investing is something Buffett can speak of with good authority.
With his financial acumen, He deemphasizes the concept of diversification in investing.
He believes the concept is only needed when the investors need help understanding what they are doing.
Those were his words, but has he been able to prove them in action?
Buffett’s Portfolio
Let's compare the number of stocks Warren Buffett had at the beginning of his investing career to his current portfolio.
In 1941, when he was just 11 years old, Warren Buffett bought his first share. He bought three preferred stocks at one company called Cities Service for the total amount of $114.75.
His net worth at the time was $120, so technically he went all in on the investment. Very little diversification here.
By the time Buffett was 19 years old, he had a change of heart.
This time, he read the book “The Intelligent Investor” and attended Columbia Business School to study value investing under the tutelage of Benjamin Graham who is an economist, professor, and investor that influenced the lives of many successful men, including Buffett.
In fact, he served as Buffett’s role model. Graham also managed an investment company called Graham-Newman Investment Partnership, which had a portfolio with over 100 positions in 1951, although it is quite top-heavy.
Perhaps Buffett was influenced by his role model's mode of investment, he reassessed his portfolio and diversified it to seven holdings.
By January 1962, Buffett had achieved millionaire status. All thanks to his investment partnership, Buffett Partnerships Ltd.
We know that Charlie Munger was one of his partners, but not much else is officially revealed about the partnership positions of the business. What Buffett did reveal in his partnership letters was hints about his portfolio allocations.
In 1962, he wrote:
We usually have fairly large positions - 5 to 10 percent of our total assets - in each of five or six generals (Buffett used this term to refer to one type of investment in the partnership), with smaller positions in another ten or fifteen.
While in 1966, he wrote:
We’ve only had five or six situations in the nine-year history of the partnership where we have exceeded 25%. And also, we presently have two situations in the over 25% category - one a controlled company (Berkshire), and the other a large company (American Express) where we will never take an active part.
Based on this information, we can still safely say Buffett was focused back then. He has yet to indulge in diversification fully.
But the picture is different now. Under the name of his investment company, Berkshire Hathaway, Buffett owns 30 to 40 stocks in different companies and more than 50 in wholly-owned subsidiaries.
It isn't easy to discern his current portfolio as most of these companies must be listed. But from the number of stocks he owned, it’s still top-heavy but not as focused on a small number of companies as he was in the past.
He's practically practicing diversification, which he doesn't support.
Does this situation mean Buffett prefers a 100-company portfolio to a 10-company one now?
Or is it because he's now older and wiser that he isn't interested in concentrating on his portfolio?
Well, we can't get answers to these questions if we're considering Berkshire Hathaway's worth.
Considering the world today, opportunities arise every day, and just concentrating on one will make you lose out on the rest, which can potentially be superior to the one you choose. So, Buffett would have preferred to diversify.
But at the same time, there are rules to this diversification, and we'll take a look at the four rules of thumb which Warren Buffett would use to determine the number of stocks you should have in your portfolio, whether it’s a few or many.
It's worth noting that these rules also apply to other types of assets, such as real estate or bonds.
Rule 1
The first one is, Are you a beginner investor?
The basic premise behind diversification is not to put all your eggs in one basket.
When you're just starting out in the world of investing, many concepts are foreign to you, so you have to be careful each step of the way because you need to learn how the market moves.
If this sounds like you, then diversification would be a good idea.
Warren Buffett said that diversification is for the ignorant.
But if you're a seasoned investor, you can analyze and find out a stock’s value, and it might make sense to invest in less than 30 to 50 stocks.
However, if you have no idea what you are doing, investing in individual stocks can be a gamble, and you can never predict which one will be profitable.
This is the issue that Buffett and other seasoned investors have with diversification.
While it’s true that diversification can reduce the risk of severely underperforming the market, on the flip side, it also limits your ability to outperform the market by a wide margin.
Therefore, if you are experienced in the stock market, you only need to study in-depth into one or two industries, learn their ins and outs, and use that knowledge to make a huge profit.
In other words, the more knowledge you have about individual companies, the less you need to diversify.
On the other hand, an index fund is suitable for people who lack the know-how or cannot devote time to security analysis to stay up to date with a company’s earnings.
This is consistent with what Buffett said in 1993:
By periodically investing in an index fund, for example, the know-nothing investor can out-perform most investment professionals.
Rule 2
The second rule is, Are you investing in risky assets?
When determining the number of stocks you should have in your portfolio, the riskiness of every business model should also be considered.
The riskier the investment you're going for, the more diversification you'll need.
Just a single unprofitable risk can lead to the total collapse of an individual's wealth. And some other risk can be an inadequate return on the capital you put in.
So what you need to avoid in terms of riskiness are stocks where you stand a good chance of losing everything if things go wrong, such as startups, bankruptcy cases, and businesses in rapidly changing industries.
It would help if you focused on companies with strong fundamentals, competitive advantage, reliable management, and consistent earnings growth.
Additionally, keep an eye out for similarities between your holdings.
For instance, your diversification won’t make a difference if you have 20 different healthcare companies in your portfolio. You should invest in different asset classes, such as stocks, bonds, real estate, and metals.
There's no difference between investing in twenty similar companies in the same industry and investing in a single company.
The theory is that different asset classes tend to correlate negatively, so an investor's entire portfolio will not perform poorly if one or two assets perform poorly.
When it comes to the stock market, it should be in different companies. Every business model has its own risk; some are more manageable than others.
Rule 3
The third rule is, Are some opportunities better than others?
A reason for diversification is to save you from the disadvantages of ignorance.
But if you're a professional investor, that is, you would know the ins and outs of the business in your circle of competence, then not overweighting the best one in your portfolio is, frankly, madness.
By sticking to the companies that you judge to be attractive after thoroughly analyzing them, you would be able to raise your portfolio’s expected returns compared to if you had weighed your top 25 ideas in your portfolio equally.
As Buffett did with Apple today, he could predict their efficiency in giving him the returns he wanted.
So, he made Apple his largest holding in his portfolio.
However, suppose you're a know-nothing investor, borrowing Warren Buffett's words:
knowing the perfect business might be difficult since you're still new and just tasting the concept of investing.
In that case, diversification is here to help. You can invest in a wide range of businesses and still achieve a respectable rate of return.
Rule 4
The fourth rule is, Can you earn it back?
Yes, this is a great question.
Can you earn the capital you put into the business back?
If your investment doesn't go as expected, do you have another method to recoup your capital?
Your level of investment career depends on how much you earn.
If you only have one month of salary, you could put all of it into a single stock; that isn't a big deal if you will earn it back in the next month.
But it would help if you thought of diversification if it takes a couple of years to earn back your capital through your job.
Ideally, you would be focusing on picking the best stocks to buy, as you can never predict if your investments won’t perform as you had expected it to.
In summary, you should concentrate your portfolio more if you are a professional investor, are investing in assets with lower risk, are expecting larger returns from the opportunities you invested in, and can replace your capital through income fairly quickly.
Although this is not a fool-proof plan, it can serve as a helpful guide to determine the number of stocks you should have in your portfolio.
And that's a look at the views that Warren Buffett has on the number of stocks you should have in your portfolio.
Do you agree with these rules?
And how many stocks do you have, or are you planning to buy?
- Ivan