Bottom Line/Personal: Many investors own dozens or even hundreds of different stocks because they want to be sure to be where the action is when the market goes on a hot streak. But unfortunately, that kind of thinking is exactly wrong, according to my guest today. He says that owning many different stocks is exactly why lots of investors end up with mediocre returns—even when there is a hot streak. So, how many different stocks should you own?

I’m Steven Kaye, editorial director of Bottom Line Publications, and this is Bottom Line On Your Money, where our experts help you create, invest and protect your wealth.

Today I’m speaking with Vahan Janjigian, PhD, CFA. Vahan is editor of the MoneyMasters Stock Report newsletter, chief investment officer at Greenwich Wealth Management and author of two books, including Even Buffett Isn’t Perfect. Vahan is a legendary stock picker, and he’s known for keeping a relatively small number of stocks in his portfolio.

So Vahan, welcome. Thank you for coming out today. Now tell me, why might it be a problem to have many stocks in your portfolio?

Vahan Janjigian, PhD, CFA: The whole purpose of diversification is to reduce risk. That’s why investors are often told that they should have a diversified portfolio, so that they can reduce the risk of their portfolio. It can actually be mathematically proven that you can do this.

Investors don’t often realize that when you have a diversified portfolio, you’re also limiting the upside. It’s not just the downside. So by being extensively diversified, you’re pretty much guaranteeing that you’re going to get the market return. So however well the market does or however poorly the market does, that’s how you’re going to do if you’re extensively diversified.

And if that’s what you want, there’s nothing wrong with that. If that’s what you want, you shouldn’t be picking stocks at all—you should just buy an index fund. But if you’re extensively diversified, you’re guaranteeing that you won’t make a lot of money.

If your goal is to become rich by investing, you have to have some degree of concentration in your portfolio. You have to have only a handful of stocks, and you have to do quite a bit of research and make sure you’re picking the stocks that are undervalued and likely to go up the most over a long term.

Bottom Line: Let’s draw a distinction between diversification on the one hand and the number of stocks on the other. For example, I might own 100 stocks, but they might all be energy stocks or they might all be tech stocks. So obviously, that’s not diversified, and I’m thinking that I’m picking the best stocks in that sector and I’m going to be doing very, very well. Am I?

Janjigian: No, you’re not. But you know, it’s interesting, because if you look at the finance theory, the theory actually says that you can reduce risk by adding more stocks to your portfolio, regardless of what industries they’re from. So if you have let’s say 10 stocks in your portfolio and you add an eleventh, you get a deduction in risk. And risk is measured by the volatility of that portfolio.

But it turns out that this is decreasing as you add more stocks to your portfolio. So if you already have 100 stocks, then adding one more stock has only a marginal benefit in terms of risk reduction. So there is some point where you can say, I’m already diversified enough…I don’t need to add more stocks to my portfolio.

There’s a lot of debate as to where that point is. Some academics would argue that you have to have at least 50 stocks in your portfolio. Others would argue that perhaps 40 is enough. In my view, once you get up to about 20 stocks, you have sufficient diversification, yet you still leave yourself the opportunity to do really well on the upside.

Now, in the extreme, one of my favorite investors, Warren Buffett, says that if you really know what you’re doing, you can get sufficient diversification with just a half dozen stocks. I think that’s a little too few. I think it’s safer to have about 20 in the portfolio. But that also leaves you plenty of opportunity to outperform the market on the upside.

Bottom Line: I think for a lot of investors, the idea of having only 20 stocks actually sounds kind of scary. That sounds like you’re placing your bets on a small number of stocks. To you, it feels comfortable. But where’s that point of diminishing return going to be reached?

For example, if I as an individual investor am not comfortable with just 20 stocks, and I have 25 or 30 or 35, am I limiting my potential reward severely by doing that? Or does that not happen until you get many more stocks in the portfolio?

Janjigian: Think of it this way—if you own 20 stocks in your portfolio and they’re equally weighted, you only have 5% of your portfolio in any one position. So can you live with 5% in one position? I think most investors can tolerate that kind of risk.

But if you can’t, then what you can do is perhaps put 70% of your money in these 20 individual stocks, and put the other 30% in an index fund. That way, you are getting some diversification in your portfolio, extensive diversification, but that 70% that is in the individual stocks still has the opportunity to really add to your performance.

Bottom Line: So you’re creating kind of an individual best ideas portfolio of individual stocks, and then the rest of it, you’re smoothing out across some kind of index so that you have I don’t know if it’s the best of both worlds, but it’s part of both worlds.

Janjigian: Absolutely. And also keep in mind that there is no single answer for every investor. One of the things that we have to do whenever we get a new client is we have to analyze that client’s objectives and constraints. Some clients can’t tolerate much risk at all—they need to be in a very diversified portfolio. Other clients are willing to take the risk to outperform, and 20 stocks in their portfolio might be perfectly appropriate.

Bottom Line: So the idea is that no one ever gets rich by diversifying, yes? But you still have to have a certain amount in there for your protection.

Janjigian: You do, but also keep in mind that there’s no such thing as bulletproofing your portfolio, because unfortunately when there are economic crises or financial crises, investors sell everything at once. So stocks that were previously thought to be uncorrelated could become very correlated in the market sell-off, and you can’t really protect yourself from that.

Bottom Line: OK. Now, great ideas come our way periodically, and we just know that a certain company is going to do well and a certain stock is going to do well. So the flipside of keeping your portfolio down to a manageable level of stocks is that if you’re going to add one of these great ideas, you’ve got to usher something else out of the portfolio. How do you do that?

Janjigian: Well, I’m always looking at stocks, I’m always analyzing stocks, I always have my favorite stocks, and I also realize that all clients have a limited amount of resources. So if I come across a stock that I really feel strongly should be added to the portfolio, I will then often get rid of another stock in the portfolio that I think is no longer as favorable.

Bottom Line: So Vahan Janjigian thinks that 20 stocks is about right to create a portfolio that has lots of opportunity but also has some protection from diversification. Others think it may be 40 or 50, but it’s in that neighborhood.

And if you don’t feel comfortable with that, you can always take part of your portfolio, put it in individual stocks, and then put the rest in some kind of index fund, and have fun with the best ideas part. Make sense?

Janjigian: It absolutely does.

Bottom Line: Thank you very much, Vahan.

Janjigian: Thank you, Steve.

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