You may have wondered about this question before.
How many stocks should I own to be “sufficiently diversified”?
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You may have gotten advise from people (especially the finance professionals) advocating the importance of diversifying your portfolio.
Because: “Having too little stocks is risky.”
On the other hand, you may have probably also heard others stress about the importance of holding only a handful of stocks (not more than 5).
Because: “You would not have time to understand and monitor so many stocks.”
So…who is right?
I admit, this is not an easy question to answer.
In fact, I would like you to answer more questions:
- Do you want to be rich, or are you happy with accumulating wealth steadily?
- Do you have the temperament required to be rich?
Warren Buffett’s Secret
Many people believe that Warren Buffett became rich because of his phenomenal stock picking ability.
It is not exactly true.
His real secret to getting rich is by concentrating his bets. He has shared this many times throughout his life, but most people did not pick up on it.
One of the favourite analogies is got to be about the baseball player, Ted Williams.
Ted is considered the best hitter in baseball. His secret is to only swing the bat when the ball is in his sweet spot. Otherwise he will do nothing.
Warren Buffett said that investors should behave like this. Do not invest in every opportunity that shows up, be selective.
Only when you are confident that an obvious investing opportunity has arrived, then you must make sure you bet enough and not too little.
In the early part of Buffett’s career, he bought similar stocks as his teacher, Benjamin Graham. But he invested a lot more capital per stock compared to his teacher. This allowed him to grow and compounded his wealth at a faster rate, making him a millionaire in his 30s.
On another occasion, he shared a tip with a batch of graduates;
“I always tell students in business school, they’d be better off when they get out of business school to have a punch card with 20 punches on it. And every time they made an investment decision, they used up one of their punches, because they aren’t going to get 20 great ideas in their lifetime. They’re going to get five or three or seven, and you can get rich off five or three or seven. But what you can’t get rich doing is trying to get one every day.”
You have to concentrate your investments, if you want to be rich. Have as few stocks as possible, 5 probably.
But you must be very confident that your stock picks will work out for you.
How do you know?
You will need to develop the skill to know your edge.
So a new investor should not concentrate his bets, not at the beginning.
Buffett’s success did not come so much from his stock picks. Instead, it was due to the big bets made in the right stocks that mattered.
If it has not hit you yet, here’s the major takeaway from what Buffett has said:
And if you invest in Buffett-like stocks but you do not make a big enough bet, your returns are going to suck.
And, it seems like George Soros agrees…
Soros is another revered investor. Stanley Druckenmiller was a lead portfolio manager for Soros from 1988 to 2000 before he started his own hedge fund. He learned an important lesson about achieving high returns. In The New Market Wizards, he said,
“Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.”
Soros has discussed about making big bets,
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
Most people are concerned about the accuracy of their stock picks.
They prefer to see all stocks make small profit each, rather than to see one stock making huge gains while the others are losses. The way to think about this is not to be bothered by the frequency you are right, but whether you place a big enough bet when you turn out to be right.
Why Real Estate Investors tend to do better (nope, it’s not because they are better investors)
Properties are capital intensive. It requires several hundreds of thousands to pay a deposit for a property in Singapore. And usually buying one would suck up most of your capital. Property investing by itself is a big bet. You cannot really diversify your properties unless you are really very rich.
Stock investors on the other hand could diversify easily, either by sectors or geography.
Most people have heard stories of “some rich guy” who made a lot of money when his house was en bloc. But rarely hear stories about “some rich guy” making money from stocks.
The inability of diversification in property investment is one of the reasons why real estate investors did better. Because they know it is a big bet and hence they are more careful about making the investment decision. And once they sink in the money, they do not really think about selling them until they really see a sizeable profit.
Few stock investors actually put all their capital in stocks, lest to say on a few stocks. They often invest in many other things like endowment, ILPs, Unit Trusts, Bonds, gold, silver, bitcoin, wine, land banking, etc. Because not all these investments do well at the same time, their average returns are lowered as a result.
The Kellys vs the Markowitzs: Why conventional wisdom will keep you from being rich
Edward Thorp is the famous mathematician who aced the Blackjack game and won money from the casinos. His disclosure of the card counting strategy caused casinos to change the rules of the game – use four decks instead of one and reshuffle more frequently.
The strategy was to bet small when there’s no edge and bet big when the edge is on your side.
Poker players use a similar strategy as well. Bet big when your cards are awesome.
Thorp went on to manage money and continue to bet big on high conviction trades. His fund performance were averaging above 20% per year. He used formula known as the Kelly Criterion to optimise and guide his bet size.
Kelly criterion would ensure you grow your money at the fastest possible rate without bankrupting you. Under- or over-betting would result in suboptimal returns.
The academics slammed this philosophy and preferred the Markowitz’s diversification story.
The story is that it is futile to aim for highest returns because the path (risk) to achieve it should be considered as well. A very volatile portfolio value would make an investor very uneasy. Hence, the more sensible method is to choose a diversified path where volatility is reduced to a more acceptable level.
This line of thought went on to dominate the financial industry thinking – Unit Trusts and ETFs are all about diversified investments. You can see their returns are largely similar. Some Unit Trusts even hold stocks similar to those in the indices, they are simply known as closet indexers. Only the hedge funds would make huge bets, hence their returns are dismal when their bets go wrong.
Here’s the hard truth – you cannot get rich with a diversified portfolio. You can only grow your wealth at a decent rate. If you see rich people with diversified portfolios, it is likely that most of their capital came from huge savings from their income instead of investment returns. Or they could have made big bets in the early part of their lives and now are in preservation modes.
So…back to the additional questions I’d asked at the beginning:
Be rich or to grow wealth steadily?
The answer to how many stock you should have in your portfolio lies in your answer to the question above.
Through this article, I hope you get a better understanding about diversification.
If you aim to be rich, you have to concentrate your investments to a handful of ideas and make sure you bet big on them. Unfortunately, it is going to be a hell of a ride. So, make sure you have the temperament to handle the wild ups and downs.
If you can’t, then don’t do it.
If you aim to grow your wealth with preservation as a priority, a diversified portfolio is more suitable. It would give you less heartaches and sleepless nights. But don’t expect to be rich, if you are not a great saver.