This week's Blue Harbinger weekly is a direct follow-up to a member inquiry about "what is an appropriate number of stocks to own?" First of all, if you’re going to put a significant portion of your nest egg in the market, you probably don’t want to put it all in just one stock (too risky!) But how many positions should you hold? There are academic studies that suggest at least 25 to 30 stocks is enough to garner all the main benefits of diversification, but still—there are additional important things you need to consider. This article describes how we construct our portfolios at Blue Harbinger, and will hopefully help you garner some important ideas as you build and manage your own.
Should I Even Be Investing In The Market?
You might want to start out by asking that very question. After all, the market is risky and volatile, and some people simply cannot handle that. For example, the above chart shows how the volatility (as measured by standard deviation) of an investment portfolio is reduced as the number of stocks in the portfolio is increased. As a general notion, the annual returns of an investment portfolio fall within 1 standard deviation about two-thirds of the time, and about 2 standard deviations about 95% of the time. This means if the market returns 8.5% of average, in any given year you can expect 8.5% each year, plus or minus 15% (~1 standard deviation in the chart) two-thirds of the time if you’re holding a 30 stock portfolio. And your can expect and annual return of 8.5% plus or minus 30% (~2 standard deviations) roughly 95% of the time.
If you have a big purchase coming up in the near future, or you need the cash for something else, then investing in the stock market may not be appropriate because of the volatility (i.e. you should probably set some cash aside for your cash needs). However, very importantly, over the long-term, the stock market can average about 8.5% per year, and if you have a longer time horizon (i.e. you can handle some short-term volatility), then the stock market can be a truly fantastic and powerful way to grow your nest egg.
The 25-30 Position Thing:
There are some catches to the “25 to 30” position thing. For example, these numbers assume you're not putting all your investments into one sector or style. For instance, may investors focus so heavily on income investing that they end up investing almost all of their money in only one or two market sectors, such as high-yield REITs or Utilities stocks. This is not good diversification because all sectors go in and out of style, and it can be particularly painful when the sector you are invested in is out of style. For example, REITs have significantly underperformed other market sectors significantly since President Trump was elected, and if you’ve been invested in all REITs then you missed out on some very significant gains. Or worse, if you’ve been sitting in all cash for the last 10 years because you were so afraid of the housing/financial crisis, then you’ve missed out on extraordinarily strong returns. and wealth appreciation power.
As yet another example, some investors were chasing the technology sector, and got burned badly in the early 2000’s when the “tech bubble” finally burst.
All of our Blue Harbinger portfolios are constructed to take into consideration appropriate levels of diversification. Having prudent diversification is powerful and very important.
ETFs Provide Instant Diversification? Or Do They?
Exchange Traded Funds, or ETFs, have become very popular in recent years, and we even use them sparingly in some of our Blue Harbinger investment portfolio. However, investors need to be careful of a couple things before they invest in ETFs.
First, some investors incorrectly assume that ETFs provide instant and appropriate diversification. While it is true most ETFs hold far more than the 25-30 stocks mentioned above, however many ETFs often focus on a specific sector (e.g. tech stock ETFs) or style (e.g. momentum ETFs). Many investors incorrectly assume they’re appropriately diversified by owning any ETF. They’re not!
Secondly, ETF can be expensive. While many ETFs offer very low fees, many do not. ETFs with fees of around 0.20% per year or less might be worth considering, in our opinion. However, some charge 5 or 6 times that much, and that’s just too expensive and inappropriate for an ETF in our opinion. Especially considering you can get appropriate diversification on your own without paying any management fees.
Do Your Homework!
Some people build their own investment portfolio whimsically, by basically just throwing darts at a board. If you’re going to do this then you might as well just buy a few broadly diversified (across styles and sectors), low cost ETFs.
Others manage their own investment portfolios, but suffer the negative consequences and risks of trading too much. For example, trading is not free in most places. Many brokers charge $6 to $7 (or more) per trade. And there are hidden trading costs too (e.g. bid-ask spreads). And depending on the size of your investment portfolio and how often you are trading—these fees can really add up (in a bad way!). Be cognizant of these expenses, and trade wisely (diversified, low-cost, long-term investing is a proven strategy for success!)
Another risk to watch if you manage your own investment portfolio is “cash drag.” Plenty of investors place sell trades, but then forget to subsequently buy anything with the cash. If your cash balance is too large you end up missing out on the longer-term returns of the market. This is called the negative impacts of “cash drag,” and it can become a very big problem (opportunity cost) over time. If you’re going to invest, make sure you stay appropriately invested so you miss out on the dangers of too much “cash drag.”
We’ve taken all of the above (and more) into consideration in constructing our Blue Harbinger investment portfolios in order to achieve their stated objectives (e.g. income, capital appreciation) without taking on an unnecessary risks. And we hope that this information is helpful to you in building and managing your own investment portfolios. For reference, you can view all of our investment portfolios and current holdings here.