What is the optimal number of stocks?

The case for portfolio concentration for the small investor

Today, we look at a question that every investor needs to contend with. How many different stocks should I own? This question can be summed up as: How willing are we to dilute returns from our best ideas, in order to reduce stock-specific risk?

Let’s start with a poll, then get into the details:

*Results will be posted in a future article when polling is complete.

Life and investing are probabilistic in nature. As investors, we aim to predict the likelihood and impact of different future scenarios. Since we never want to be wiped out from the investing game completely, a degree of diversification offers some necessary safety.

But how much is too much?

(Unless it’s a great basket)

Owning too many stocks can result in “di-worsifying” our assets. We might lower our percentage of top performing ideas and our overall returns. The exact number of holdings that make up a “concentrated” or “diversified” portfolio is essentially arbitrary. There are no set definitions. In addition, the total number of positions does not fully capture the portfolios focus and weighting. For example, someone may have one big 50% position and fifty 1% positions. They appear to be highly diversified based on the total number of companies, but their fortunes overwhelmingly depend on one business.

The size of the largest positions is more important than the total number of positions in determining concentration.

Research models have their problems

You may have read generalizations such as “8 positions reduce stock-specific risk by 70% ” or “30 positions reduce risk by 95%.” Many of these maxims originate from academic models (such as the work by Fisher et al. in 1970). They examined a reduction of return distribution (standard deviation of returns) with an increasing number of stocks. These principles sound intuitive; having a higher number of holdings will lower our stock-specific risk. There are diminishing benefits as the number of holdings grows (see below).

Although the general philosophy makes sense, there are several limitations:

1. An underlying assumption in these models is that risk is divided equally among companies. If we add x number of companies to the portfolio, we mathematically decrease our risk by exactly x-percentage. The issue with this is the implication that we are randomly choosing our holdings, just as the models considered random combinations of listed companies. This is contrary to value investing, where we are choosing companies that decrease our risk relative to the potential returns. We are not picking companies out of a hat.

2. Risk does not necessarily follow a perfect normal distribution of outcomes, it may be represented by a a very skewed distribution of possibilities in the real-world.

3. Models look at correlations of returns based on past years of stock price data. They do not assess causal factors underlying that data, which may make those correlations less applicable in the future. It also assumes that the market is precisely determining the value of the business through share price changes at all times.

4. It is incorrect to equate volatility (standard deviation of share price) with investment risk. Reducing volatility is NOT the same as reducing risk. Volatility might be correlated with investment risk —if the market’s assessment of a company is accurate over time— but it is not the same as the true risk of a permanent loss of capital. We should study companies and not the erratic behavior of squiggly lines. As John Templeton summed up: “The notion that building portfolios on the basis of unreliable and irrelevant statistical inputs, such as historical volatility, was doomed to failure.”

Instead of looking at abstract models for optimal diversification, we would be better served by looking at the strategies employed by the most successful investors in the real world. By studying both their words and actions, we may improve our investing performance.

The case for a concentrated strategy

Warren Buffet (early Buffet):

Decades ago, a young Buffet practiced a very focused investment strategy. In his early 20s, he went as far as putting 65% of his net worth into GEICO. He felt it was the lowest-cost provider in the insurance industry and had a long growth runway ahead. The PE ratio was only 8 at the time which increased his margin of safety. After starting his own partnership he continued using a concentrated strategy, as outlined in his 1966 Buffet Partnership letter:

“…five or six situations in the nine-year history of the Partnership where we have exceeded 25% (position size).”

Most financial advisors would consider a 25% bet to be excessive. Yet, Buffet was willing to make heavy bets even after transitioning to Berkshire and operating with larger sums of money. Here is quote from the 1993 BH annual letter:

“Charlie and I decided long ago that in an investment lifetime it’s just too hard to make hundreds of smart decisions…Therefore, we adopted a strategy that required our being smart—and not too smart at that—only a very few times…We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.”

Here he outlines a psychological advantage of concentration. If you bet heavily on just a few companies, you are more likely to closely track them and do the necessary homework. Individual investors with hundreds of positions won’t have the time or resources to track them all. At that point, you might as well buy the index.

As late as 1989, Berkshire derived income from 9 wholly owned companies and 5 partially owned marketable securities. Even more recently, Apple accounted for about half of Berkshire’s public equity portfolio in 2023 due to significant share price appreciation. Berkshire has since reduced its position in Apple to re-balance and capture capital gains. During the 1996 BH annual meeting, Buffet states:

"We think diversification is — as practiced generally — makes very little sense for anyone that knows what they’re doing. Diversification is a protection against ignorance..."

So what is his recommendation for smaller investors?

"If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea.”

Today, Berkshire is invested in 38 public stocks alongside many wholly-owned companies. Top 10 holdings account for 89% of the public stock portfolio.

Charlie Munger:

Charlie had perhaps an even more extreme view on concentration than Warren. The Daily Journal portfolio which he controlled had 5 U.S-listed positions. In 2017, he mentioned that his personal family portfolio consisted primarily of 3 holdings (Costco, Berkshire and Li Lu’s Himalaya fund).

“If you want the standard result and don't want to end up embarrassed - then of course, you should widely diversify. But nobody is entitled to a lot of money for holding this view.”

The Ben Graham old school approach:

The “father of value investing” outlined a fairly clear and simple approach to portfolio construction in his book the Intelligent Investor. He broke down stocks into 3 primary categories based on their risk profile:

• Defensive stocks (cheap, steady earnings, good balance sheet) - Not more than 10% allocation each.

• Enterprising (growing earnings) - Not more than 5% each.

• Net-nets (cheap relative to asset value, cigar butts) - not more than 3.3% each.

Depending on your combination of these 3 categories, you end up with 10-30 companies. This is a reasonable starting point for most investors.

Insights From Other Investors:

• Li Lu: 8 positions (Top 10 holdings: 100%).

  • “It’s truly rare to find no-brainer opportunities, but when they do arise you bet heavily and not think about diversification. In the end it boils down to opportunity cost.”

• Mohnish Pabrai: 5 positions (Top 10 holdings: 100%).

  • “We've got 10 to 15 positions versus 500 positions in the S&P500. Our mostly uncorrelated industries gives us diversification."

• Michael Burry: 13 positions (Top 10 holdings: 93%)

  • “Investors should own a concentrated portfolio of high-quality businesses that can deliver strong organic growth even if the economy falters.”

• Nick Sleep: During his Nomad Partnership years, he had 20-30 positions with ~80% of his capital in the Top 10. Later on, he transitioned to holding just 4 stocks in his personal portfolio).

  • “We would propose that if knowledge is a source of value added, and few things can be known for sure, then it logically follows that owning more stocks, does not lower risk but raises it!”

  • “Sam Walton did not make his money through diversifying his holdings. Nor did Gates, Carnegie, McMurtry, Rockefeller, Slim, Li Ka-shing or Buffett. Great businesses are not built that way. Indeed the portfolios of these men were, more or less, one hundred percent in one company and they did not consider it risky! Suggest that to your average fund manager.”

  • “We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could drastically change the underlying value of the investment.”

• Chris Hohn: 10 holdings (Top 10 holdings: 100%)

  • “We run concentrated positions – can be in excess of 10 percent of NAV [Net asset value]. And so by concentrating our capital in a handful of very good ideas where we find the alpha it can mean something and can outperform.”

• Seth Klarmann: 21 holdings (Top 10 holdings: 80%)

  • “The number of securities that should be owned to reduce portfolio risk is not great; as few as ten to fifteen holdings usually suffice.” Seth Klarman

• David Teper: 37 holdings (Top 10 holdings 66%)

  • "You can't make money with a diversified approach." David Tepper

*It should be noted that only U.S listed positions are disclosed in 13F filings and not international holdings in other markets.

What about very diversified portfolios?

While it seems that most value investors advocate for a concentrated portfolio, we might notice that some of the largest funds in the world are massively diversified… In some cases they own more stocks than the S&P 500 index! A few notable investors with highly diversified portfolios today include Howard Marks (160 holdings), Ray Dalio (691 holdings) and Joel Greenblatt (1421 holdings).

It should be noted that Joel Greenblatt started off his career as a concentrated investor while achieving 40%+ CAGR over a decade in the 1980s/1990s. At this point his fund was much smaller and there were more investment opportunities available. In previous lectures he states that ~80% of capital was put into just 6-8 positions. The trade-off was that he suffered through years of high volatility and under-performance, even though the overall long-term returns were extraordinary. His current approach today with large-scale diversification (combining many long and short bets) only started after his AUM grew into the billions.

Another key example is Peter Lynch. He achieved a 29% CAGR from 1977 to 1991 while practicing heavy diversification. He even managed up to 1400 stocks in 1989! Despite the strategy he employed at Magellan, he said this when discussing small investors:

“It isn’t safe to own just one stock, because in spite of your best efforts, the one you choose might be the victim of unforeseen circumstances. In small portfolios I’d be comfortable owning between three and ten stocks.”

Why do larger funds remain so diversified?

There are a few reasons…

1. Large funds often have risk-averse clientele like sovereign wealth funds or university endowments. Their goal is often capital preservation and consistent growth in a variety of economic environments. There is a greater emphasis on risk reduction rather than maximum returns.

2. Buying small cap companies can drive up the price due to low liquidity, therefore their investing universe is much more limited. This forces them to either buy into large cap companies (where there may not be any good opportunities), or to diversify widely into many smaller bets.

3. Many funds choose to keep their ownership of a company <10% to avoid additional reporting requirements, forcing them to spread their capital.

4. Fund managers are risk averse as they could lose their job if they are wrong, or lose capital from their clients if they have a low performing year. Small individual investors can’t fire themselves (I think) and can focus on the long-term.

5. They employee large teams of analysts. Big operations have the manpower and computing power to keep up with thousands of stocks.

Some gentlemen engaging in active diversification.

Concentration should be correlated to information

Most business owners have a majority of their net worth tied to their business, yet society does not question this level of concentration. An investor owning a single stock would be considered outrageous by most.

Why is this?

The difference between the two is that the business owner has a significant informational advantage over the minority investor. An owner runs the company’s daily operations and has a more unique insight into its trajectory. In addition, the owner can make changes to the business and has far greater influence over its future. Therefore, passive investors necessarily requires more diversification than the business owner.

If our aim is to maximize risk-adjusted returns, then the size of our investment in a company should be tightly correlated with our own knowledge of the company and its industry (be honest with yourself). Superior knowledge and insight is what offers us a more accurate assessment of both the upside and downside scenarios. We should try to be objective and recognize our own circle of competence. Our level of investment in a company may grow over time as we gain comfort and acquire new information, which favors a DCA approach. Some diversification is needed regardless of our informational advantage in case of unforeseen Black Swan events. Events can happen that could not have been predicted ahead of time. We must accept this.

Final thoughts:

For a small investor with a long runway ahead, the ability to be heavily concentrated offers a significant edge for maximizing returns. If done properly, concentration can be employed without substantially increasing one’s risk.

More specifically, I favor a concentrated portfolio with 8-15 holdings, diversified across industries and geographies. I aim for the top 8-10 holdings to account for 80% of the capital. My portfolio will starts off a little broader than these numbers and can slowly be fine-tuned and chiseled down, like a marble sculptor.

What is your approach?

- Stock Doctor

Disclaimer: This article is for informational and educational purposes. This is not financial advice. Investors should always do their own due diligence.