It might sound logical to have a diversified stock portfolio. You can easily protect yourself from the things you do not know by owning more positions, and therefore you can get the average of the market. However, many mutual funds have diversified, yet most have failed to get the average, still doing good but not the best. So, should you diversify? How to diversify? And how many stocks should you own?
In general, diversification is protection against ignorance. In value investing, you should only own what you fully understand and are confident of its management and economic moat. Diversification is a way of overlooking those principles by owning market tracking ETFs, which is the best way to diversify compared to picking stocks individually, which is not the best way to diversify.
How many stocks should you have in your portfolio
If diversification is not the way, then how many stocks should you own? It might be a good idea to check what the super Investors think and how many stocks they own. Well, if you check the size of their portfolios and the number of stocks they own, you will see a pattern:
- There is no right or wrong number in owning stocks, basically whatever number you are comfortable keeping tracking off and having the capital to invest in.
- Only own what you understand. If you follow successful investors, they always emphasise that investing is buying companies you understand, not gambling by trading stocks.
- The largest positions in your portfolio that are allocated the most capital are the ones you are most bullish on. It makes perfect sense to put more money into low-risk, high-return investments. While it makes little sense to put an equal amount in all your investments, especially if some might not generate as much return as others. So doing your due diligence is highly critical.
Listen to how Warren Buffett and Charlie Munger answer the question regarding diversification in the 1996 Berkshire Hathaway annual meeting:
“Diversification is protection against ignorance It makes little sense if you know what you’re doing”Warren Buffet
Summary of the Video
Warren Buffett points out that he would invest more if he could find more wonderful businesses. However, unfortunately, there are not many wonderful businesses that one person can understand. Diversifying by owning, for example, 30 stocks is protection against ignorance because do you realy understand all those stocks? Because if you do, you will not have that many stocks.
People get rich by owning a few businesses, not a large portfolio of businesses. A good company will have a good moat that protects it against its competitors. If you want to do better, make a condensed portfolio with businesses with an excellent competitive advantage that can give you more than average. If all you want to do is average, then diversification can give you that.
How many stocks superinvestors usually own
Based on the information provided to us by superinvestors through the SEC filing, we can compare their portfolios by the number of stocks and position size to determine the average number of stocks they own. For this comparison, we will use portfolios in the Q3 of 2021.
1- Warren Buffett – Berkshire Hathaway
If you look at Warren Buffett’s latest investments, you will see that he holds a total of 43 stocks which you might think that Warren Buffett does not follow what he preaches. His portfolio might look like it is extremely diversified. Yet if you look at his top 5 positions, they occupy more than 77% of his entire portfolio, and the rest is less than 3%. Most of the other investments are less than 1% of the whole portfolio.
Moreover, Warren is not the only decision-maker in this portfolio. There are executive officers and directors within Berkshire that control some of the assets in the Berkshire holdings. Berkshire Hathaway has over 293 Billion assets under management which makes sense that Warren is not the only decision-maker in this portfolio.
However, based on what we know, investments such as Apple, Bank of America, American Express and Coca Cola are investments that Buffett praised on many occasions. They occupy the top 4 of his portfolio, which is over 73%. Therefore, we can confidently say that the largest positions in Berkshire are made by Buffett, and if we look at only those four investments, we can see that it is quite a constrained portfolio.
2- Charlie Munger – Daily Journal Corp
Munger portfolio is extremely concentrated, with only 5 positions. Munger acts very infrequently to his portfolio while holding the position for an extremely long time, letting the compounding interest do its magic.
3- Mohnish Pabrai – Pabrai Investments
4- Michael Burry – Scion Asset Management
5- Guy Spier – Aquamarine Capita
Overall we can conclude that there is no magic number of stocks you should own, and it makes little sense to diversify if you know what you are doing. Those value investors are successful because they follow a proven strategy which is to invest in what you understand, under good management with excellent moat and only buy under the intrinsic value with a big margin of safety.
Investing in your top best ideas will serve you well compared to investing in number 10 or 30 ideas. You can never beat the market if you think like fund managers, even though they do not usually beat it.
How to diversity through ETFs
Suppose the market average is what you after. Getting a 7% or 8% annual return is not bad. If you can not analyse businesses individually, you should not own individual stocks; you should just own ETFs. Ignorance is your superpower; you will diversify like crazy and not waste time and energy going through balance sheets and annual reports. Simply find market tracking ETFs that you like and buy.
Investing in ETFs such as S&P 500 or the Russell 2000 is an excellent way of diversifying, and you do not have to worry about the short term ups and downs of the market. Just sit back and watch the compound interest do its magic.
The best way to invest in ETFs is to do a dollar-cost averaging (DCA), which is investing small amounts throughout the year and in a periodic manner. This way, you can avoid putting a huge chunk of your money at once when the market could be very high. You will catch the market average in the long run by doing so. Check this article to learn how to invest in ETFs through DCA: Complete Guide To Invest In ETFs.
Get the best of both worlds and diversify like crazy
You can get to the best of both worlds by investing in individual stocks and ETFs. You do not have to stick to one side and follow that to the end. You can keep investing in different ETFs by doing dollar-cost averaging (DCA) while you keep looking for wonderful businesses you can understand and can buy under a good margin of safety.
In most cases, you are not as good as the world’s best investors: Warren Buffett, Charlie Munger or Mohnish Pabrai, and that is okay. Realising that can help you pursue both ways by diversifying in ETFs that will give you the market average while also looking for a business you will be proud to own.
Currently, most of the businesses in the market are overvalued. Therefore, buying them now is setting yourself for a huge loss, which is why you should keep investing in ETFs. While patiently waiting for the perfect opportunity.
If you found this post helpful, you may also like to read: