How many stocks should you own? Rob Wherry of SmartMoney.com takes an interesting look at that question today on The Wall Street Journal’s web site.
Wherry examines “focused funds” (those that own fewer than 50 stocks), narrowing the list down to 18 that meet performance, fee, sales load, and manager experience requirements. Among the funds with the best five-year track records: CGM Focus (3.9% average annual return) and Forester Value (3.5% annual return), run by two gurus we’ve looked at here before, Ken Heebner and Tom Forester.
Perhaps more interesting than the fund screen is some data Wherry provides on diversification. According to one study he cites (from University of Albany Professors Hany Shawky and David Smith), funds that hold 100 to 150 stocks produce better risk-adjusted returns over time than funds holding only 30 or 35 stocks.
But, notes Wherry, Joel Greenblatt — one of the investing greats upon whom I base my Guru Strategies — has said that investors can cut nonmarket risk (risk that isn’t tied to movements of the broader market) by 81% just by owning eight stocks. After you’ve hit eight stocks, “the benefit of adding even more stocks to your portfolio in an effort to decrease risk is small,” according to Greenblatt.
In my new book, The Guru Investor, I look at the issue of how many stocks is enough to diversify away nonmarket risk. In general, I’ve found that portfolios much smaller than the 100 to 150 stock size that Shawky and Smith cite can produce very strong results. One study I reference in the book, for example — “Stock Diversification in the U.S. Equity Market,” by California State University-Chico Professor H. Christine Hsu and H. Jeffrey Wei (2003) — found that “the benefit of risk diversification is somewhat limited when the number of stocks in the portfolio goes beyond 50.” And in my own experience at Validea.com, I’ve found that focused portfolios of 10 or 20 stocks can significantly outperform the market over time.
Here’s a look at the performance numbers for all of my guru-based 10-stock and 20-stock portfolios. As you’ll see, the vast majority have outperformed the market since their inceptions, most of which came almost six years ago. (The others have been created in the past 3-5 years.)
