Is there really such a thing as too many stocks to own? What's the optimal number? 25 stocks? 50? 100?
Ask most people and they'd say they would be comfortable with five or six companies in their portfolio, maybe 10 at most. The thought of reading dozens of financial reports during earnings season would cause most investors' eyes to glaze over.
Embrace diversity
Yet legendary investors like Shelby Davis and Peter Lynch eschewed the narrow view and built broadly diversified portfolios of high-quality stocks. Davis owned a thousand stocks in his portfolio and turned a $50,000 grubstake into a $900 million family fortune. Lynch bought hundreds and hundreds of companies as he led the Fidelity Magellan mutual fund to historic returns.
It's precisely because no stock picker can be right 100% of the time -- not even ones as good as Davis or Lynch -- that you need to plan for the inevitable dog howling at the door. When you invest, you need to expect that you'll pick a loser or two. For every NutriSystem (NASDAQ:NTRI) that goes up 1080% in one year, there are a dozen Doral Financials (NYSE:DRL) that lose more than 80% of their value. But because it's going to happen, it means you need to build up a defense network to soften those inevitable blows and lows. How?
That's where diversity comes in. In Shelby Davis' 1,000-stock portfolio, any one position occupied no more than a very small fraction of the whole. If even a few dozen of Davis' picks went bankrupt, the impact any one would have on the total would be minimal. Similarly, Lynch has noted that despite some famously bad stock picks, the wide net he cast allowed Magellan to outperform virtually every other fund for years. By broadly diversifying, they minimized their downside risk.
Expect to lose, plan to win
Your plan for diversity -- and for a winning, profitable portfolio -- doesn't have to be as extensive as those created by Davis or Lynch. I don't advocate someone actually buy hundreds of stocks. But I also don't think an investor is doing himself any favors by holding a very concentrated portfolio either. Market gyrations, stock volatility, and economic and international events can all play havoc with your portfolio, and rare is the investor who can watch such drastic and dramatic movements in a detached manner.
There's no science to picking the "right" number, but if you're the average investor trying to "beat the street" -- which isn't someone with a hand on the doorknob to retirement and not the kid just starting out with his $1,000 graduation gift -- then a portfolio consisting of as few as 20 stocks and as many as 50 is reasonable.
A portfolio of quality companies takes years to build -- don't expect it to grow overnight. Over the past four years, Motley Fool Stock Advisor has recommended nearly 100 companies to subscribers and is beating the market by an astounding 40 percentage points. Winners on this roster like Marvel Entertainment (NYSE:MVL) and Moody's (NYSE:MCO), up more than 360% and 208%, respectively, more than offset the few flubs like KrispyKreme (NYSE:KKD) and PossisMedical (NASDAQ:POSS), both of which were sold at significant losses. Even a near complete bust like Krispy Kreme is lost in the welter of a broadly diversified portfolio.
The Foolish take-away
Odds are we're not going to be the next Shelby Davis or Peter Lynch. While Warren Buffett has suggested investors have a punch card with no more than 20 great investment ideas, even his Berkshire Hathaway has gathered a broad array of more than 40 businesses under one roof. Bill Miller is another legendary investor who has managed to beat the market for 15 years running with a "focused" mutual fund of 40 or so stocks.
We can probably only dream of achieving a record as good as Buffett's, but we don't need to be as good as the greatest investor ever to have a market-beating portfolio of our own. A 30-day free trial to Stock Advisor lets you sample the selection of high-quality companies we're gathering under our roof as we build our own profitably diversified portfolio.
Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
