Only owning 30 stocks, in a world awash in index funds, probably sounds inadequate.
It’s not.
Ben Graham made the argument for owning 30 stocks in the last post. He also argued for owning an index. I say both are acceptable.
I could argue that 30 stocks are five or ten more than necessary. I once only owned five stocks, which was probably too few. Though, Charlie Munger seems to think five is adequate for him.
The point is that 30 isn’t an outrageously inadequate number. Also, what might be right for Charlie, may not be right for you or me. So don’t invest like him, if that’s the case.
But owning 30 stocks is enough because the math says so. Joel Greenblatt did the work for us in You Can Be A Stock Market Genius:
Statistics say that owning just two stocks eliminates 46% of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced by 72% with a four-stock portfolio, by 81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99% with 500 stocks. Without quibbling over the accuracy of these particular statistics, two things should be remembered:
- After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small, and
- Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
Another way to look at is how much of your portfolio are you comfortable losing if one company goes bankrupt? 1%? 5%? 20%?
With 30 stocks, it would be like losing 1/30th of your portfolio or about 3%. Really, it’s only 1/30th of the equity portion of the portfolio, if you follow Graham’s advice of portioning between stocks and bonds. So the total loss is less. For Munger’s five stocks, it’s 1/5th or 20%.
To find your number, work backward. Take 1/x% to find the number of stocks. For example, 1% is 1/0.01, which gets you 100 stocks.
Now, before I’ve convinced you to swap out the thousands of stocks you own through index funds for 30 stocks, let me say this:
- If you follow the prevailing theory that volatility is risk, owning 30 stocks is very risky. It’s not. It’s more volatile. But since volatility tends to drive investors to make mistakes (money-losing decisions in the long run), more volatile portfolios end up performing worse than a broadly diversified portfolio in the wrong investor’s hands.
- So a concentrated portfolio, while diversified, won’t protect you from volatility. Owning a basket of index funds won’t do that either. Market risk still exists — see ’08, ’00, ’87, etc. It just happens less frequently…historically. A basket of index funds can be built to smooth out the more volatile periods but it won’t eliminate volatility entirely.
- And in theory, a concentrated portfolio — built intelligently — should offer a higher chance at better returns in the long run than a broadly built indexed portfolio, but it’s not guaranteed.
Your ability to handle 30 stocks depends almost entirely on how you handle volatility.
An argument can be made that a broadly diversified portfolio helps the perception that volatility is a “problem”. For instance, the latest push to “smooth” returns is a symptom of the financial crisis. That need has always existed to some extent because most people would rather have smooth returns than lumpy returns. Unfortunately for most people, lumpy is the natural state of markets. And the cost of smoothing returns is muted returns. As Buffett said, “Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.” More people should embrace lumpy. But I digress.
My point is to push back a little bit on the trend driving index funds and broadly diversified portfolios as the best way to invest. Statements like that get tossed around as absolutes and accepted as fact while investing has a lot of grey area.
Ben Graham had a point with 30 stocks because it’s a manageable number for the average investor. He also had a point with following an index for the same reason.
Index funds are one way to build a simple low-cost diversified portfolio. A basket of 30 stocks, with a portion in bonds, is another way to build a simple low-cost diversified portfolio.
One is different from a massively growing trend. One is harder than the other.
Last Call
- Patient Investing Requires a Little Faith – Monevator
- Want to Read More About Factor Investing? Read This – Alpha Architect
- Bogle: Vanguard’s Size a Worry – Morningstar
- Ruling Out Rather Than Ruling In – Reaction Wheel
- How to Profit From Behavioral Economics – Businessweek
- How Money Became the Measure of Everything – The Atlantic
- How Evolution Designed Your Fear – Nautilus
- The Full Reset – M. Housel
- The Real Story of Automation Beginning with One Simple Chart – Medium
- The Bitcoin Boom: Asset, Currency, Commodity or Collectible? – Musings on Markets
- Gorilla Mode: What Amazon Means for the Rest of Us – Adventur.es
- How to Remember What You Read – Farnam Street
