Are Four Stocks Enough?

Today we ask a pointed question: "Do we need to add more companies to our portfolio?" This is a question that you at home should ask yourself periodically, too.

In our case, we already own four companies in which we steadily invest. Are four large industry leaders enough for a long-term investor?

The immediate response of many people is likely to be a resounding "No! Holding only four stocks does not provide enough diversification! A portfolio should include many stocks to be properly diversified -- at least fifteen, or even twenty!"

The Motley Fool has long disagreed with that common notion. Since 1994, the Fool has said that a portfolio should typically be between eight to fourteen companies at most -- just as many as you can understand and follow. The Drip Port has moved that number even lower. We've always said that we would hold six to eight stocks, but six is the more likely number. Thinking about it now, though (as we did in 1999), perhaps four companies would more than suffice. If chosen well, why not?

How many stocks do you need?
With many investment strategies (especially Rule Breakers), you're counting on a few big winners to eventually carry you, so you need to put out several lines to increase your odds of landing a big fish. In the Drip Port, however -- and as is the case with many investors -- we're only buying stable, consistent growers that offer similar potential, and so we're more likely to see balanced results from each. This means that we don't need to work as hard to find our main big winner. Hopefully we have a handful of steady performers.

Given this, suppose that we don't find any companies that we like better than those that we already own; suppose that we only find companies that we like just as much. In that case, should we buy the new companies? If we did, it would mean more accounting and tax work; it would create a need for increased knowledge and homework; it would expose us to the risks that the new investments faced; and it would divert investment funds away from our current companies -- businesses that we already understand.

On the other hand, buying more stocks would diversify our holdings further and thereby dilute the risk that we face in each individual stock. Note that adding more companies to a portfolio is a way of diversifying risks, not avoiding risks. New stocks bring new risks.

All that said, I believe that only if the opportunities presented by new purchases are truly recognized as greater than the opportunities offered by current holdings does investing in additional companies make sense. That, or we should only buy more companies if we're concerned about our current exposure to risk and we want to dilute that risk and accept the added costs and new risks of doing so.

Overall, we seek simplicity. (We tend to complicate our lives too much these days.) A simple, effective portfolio for life -- or, if you don't want to buy individual stocks, a simple index fund for life -- is a calming thought. In our case, owning a small handful of companies that we truly understand, even only four companies if it comes to that, should do the trick. We discussed this in a 1999 column, "Focus, Focus."

So, how does your portfolio at home look? Are you better off not adding more companies (at least until you sell an underperformer)? If you can't answer that question, well, then start at step one: Do you know your investing strategy? After affirming your strategy, are you comfortable with your range of holdings and your risk? Do you own too many companies? Many people do.

We'll discuss how many companies (specifically, how many Drips) a person should consider owning next week.

High-growth study and our number of stocks
This leads again to our high-growth study. In my opinion, the Drip Portfolio is well diversified, with technology represented by Intel (Nasdaq: INTC), healthcare by Johnson & Johnson (NYSE: JNJ), food and beverages by PepsiCo (NYSE: PEP), and financial services by Mellon (NYSE: MEL). (Campbell Soup (NYSE: CPB) is our "frozen" holding -- see notes below the port's numbers.) 

We are lacking some large industries, including utilities and oil and gas (Bush would disapprove), but these are not industries that we've been able to clearly understand, so we will probably never buy into them and be better off for it.

Now, as we wrote on the Drip Companies discussion board a few weeks ago, in order to buy one of our high-growth candidates, we must be confident that it will adequately outperform our current holdings after costs -- otherwise we don't see any reason to take the additional risk. One risk is the long-term costs involved -- period! If we buy a high-growth company that does not offer a Drip, we're at the whim of brokerage costs, which change. The only high-growth finalist we're considering with a free Drip is Paychex (Nasdaq: PAYX). Meanwhile, we suggested another cut from the list and we have an ongoing discussion taking place on the Drip Companies board. Visit us there to discuss the high-growth study, this column, and diversification -- are four stocks enough?

P.S. This weekend we'll mail our June investment, splitting $100 evenly between J&J and Pepsi.

Jeff Fischer has beneficial interest in the stocks held in Drip Port -- he owns 'em. Here's our quote of the week: "A corporation cannot blush" -- Henry Collins Walsh. (Fischer disagrees!) The Motley Fool has a full disclosure policy.