In his book – You Can Be A Stock Market Genius, Joel Greenblatt discusses the optimum number of positions to hold in your portfolio. Here’s an excerpt from the book:
The strategy of putting all your eggs in one basket and watching that basket is less risky than you might think. If you assume, based on past history, that the average annual return from investing in the stock market is approximately 10 percent, statistics say the chance of any year’s return falling between -8 percent and +28 percent are about two out of three. In statistical talk, the standard deviation around the market average of 10 percent in any one year is approximately 18 percent.
Obviously, there is still a one-out-of-three chance of falling outside this incredibly wide thirty-six-point range (-8 percent to +28 percent). These statistics hold for portfolios containing 50 or 500 different securities (in other words, the type of portfolios held by most stock mutual funds).
What do statistics say you can expect, though, if your portfolio is limited to only five securities? The range of expected returns in any one year really must be immense. Who knows how the crazy movements of one or two stocks can skew results? The answer is that there is an approximately two-out-of-three chance that your return will fall in a range of -11 percent to +31 percent. The expected return of the portfolio still remains 10 percent.
If there are eight stocks in your portfolio, the range narrows a little further, to -10 percent to +30 percent. Not a significant difference from owning 500 stocks.
The fact that you can drive a truck through any of these wide ranges of expected returns should lend comfort to those who don’t hold fifty stocks in their portfolio and strike fear in the hearts of anyone who thinks owning dozens of stocks will assure them a predictable annual income.
Over the long term (and this could mean twenty or thirty years long), stocks, despite the annual variability in returns, are probably the most attractive investment vehicle.
Therefore, owning a widely diversified portfolio of stocks should enable you more or less to mirror the performance of the popular market averages. In the case of stocks, doing average ain’t all that bad.
However, if your goal is to do significantly better than average, then picking your spots, swinging at one of twenty pitches, sticking to net serves, or any other metaphor that brings the point home for you, is the way to go. The fact that this highly selective process may leave you with only a handful of positions that fit your strict criteria shouldn’t be a problem.
The penalty you pay for having a focused portfolio—a slight increase in potential annual volatility-should be far outweighed by your increased long-term returns.
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