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How Many Stocks Should You Own To Control Your Risk?
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Become A Better Trader And More Informed Investor
How many positions do you need to own to be properly diversified? If you have all of your money in one stock you are at risk of losing everything if it were to crash due to some bad earnings news, accounting fraud, or even the company going bankrupt. There is no need to take big risks like that. It’s obvious that you need to have your money in multiple positions.
I’ve been trading and investing now since before 1999 so I learned a lot from experience.
Controlling the risk in your account is the most important factor when it comes to your investment success.
Those who fail to measure and control risk end up one day getting eaten alive.
People think it’s all about diversification – that’s important, but there is more to it than that.
Strengthening Your Portfolio With Diversification
Diversification means to invest in multiple markets and asset classes. So if you got real estate and stocks you are diversified to a certain extent, because if a big bear market comes in the stock market chances are the real estate you own won’t fall as much as your stocks do – and may not even fall at all.
If you own gold if the dollar goes down in value your gold will go up. Most people are diversified by owning stocks, real estate, and interest bearing instruments like bonds and CD’s.
Great diversification comes by investing in multiple stock markets. I personally invest in stocks all over the world and can help you with that. There is more to trading than the Nasdaq and New Stock Exchange. You can play speculative microcap otc stocks or big cap stocks all over the world paying dividends. I look for value plays after bear market bottoms and every year there is almost always a new bull market starting somewhere.
To control your risk in stocks you may want to use stop loss orders to keep any potential losses to a minimum. You know – cut your losers and ride your winners.
But you must do more than that if you if you are going to invest in individual stocks by owning more than one of them. Even if you manage to play only the very best stocks to buy now you still must own more than just a few of them to do this right.
Controlling Risk By Owning Multiple Positions
How many positions do you need to own to be properly diversified than?
If you have all of your money in one stock you are at risk of losing everything if it were to crash due to some bad earnings news, accounting fraud, or even the company going bankrupt. There is no need to take big risks like that. It’s obvious that you need to have your money in multiple positions.
But how many? I’m talking about individual stocks here. When it comes to exchange traded funds and mutual funds almost all of them already own multiple positions – many positions in fact. Sometimes hundreds. So if you are just thinking about exchange trades funds and other investment vehicles it isn’t so much the number of funds you own that you have to think about, but what asset classes and markets you want to invest in to be diversified. Do you want to diversify in several of them or just own one?
I wrote in my book Strategic Stock Trading that most people should have at least ten positions if they are going to buy individual stocks.
Ten is the point at which you start to get the benefits of managing risk by owning multiple positions. Owning three isn’t really enough. Owning ten is where you get most of the impact of diversification. It’s also a level at which most individual investors feel confident that they can keep track of what is going on. If you are engaging in a lot of short-term trading it may be difficult for you to own more than ten positions and keep an eye on them, especially if you are trying to study all of the news surrounding them and daily stock market action.
People have studied this. Here is data from an academic study in the Journal of Financial and Quantitative Analysis from 1987 which crunched the numbers, looking at the impact of position size on portfolio performance and risk:
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Ten is probably the right number for most people, but it isn’t the optimal number to reduce position size risk. To really get the greatest of benefit from owning multiple positions you really should own over thirty positions, and probably forty. After forty the additional benefit of owning more positions diminishes with each additional one thereafter becomes negligible. After forty you need to have a hundred to receive much more of a meaningful benefit, and it isn’t a huge difference, and after that it no longer really makes any more difference if you add more positions.
So thirty or forty is best if you are simply looking at position size risk as a factor, but is it right for you? There is a cost to multiple positions.
There is a transaction cost in doing lots of trades and the less money you are using and thereby putting in an individual position the more transaction costs matter. For example if it costs you $20 a trade than if you place $4,000 into a position you are already losing one percent after you buy and then sell it, because $40 of $4,000 is one percent. However, if you are putting $5,000 into a position and can pay cheaper transaction costs, than at say $20 a trade the fees really are small enough that they don’t really matter anymore.
If you have less than $100,000 in your account than the transaction costs involved in owning multiple positions would suggest that you shouldn’t worry about the trading fees involved in owning thirty or more positions. If more than ten position is too much for you to keep track of then maybe you shouldn’t own more than that.
However, you should ask yourself how much are you really keeping track of positions as it is? How much do you even need to? That depends on the type of trading and investing you are doing. The more short-term your holding period the more you have to watch things and the longer your holding period the less you do, but most people think they are managing their positions much more than they are – or they are doing it too much! I like to do it so I don’t have to manage them much at all.
If you invest with a long-time horizon than you really don’t need to watch your individual positions that much if you own over thirty of them or use small position sizes. The reason why is that if you are investing than you should be buying stocks, because they have cheap valuations and are in a position to go up for a long time regardless of the “news.” They should be just about to or just starting a new bull market. If you are doing that then you don’t need to watch the daily gyrations of your stocks or really pay attention to the news stories surrounding them. All you need to do is just check on things every few weeks really. Investing then becomes easy, because you don’t really have to care anymore what the stock does in any one day and most news stories have little impact over a few years.
Now knowing what stocks you should buy is another matter. Through years of experience and looking at stocks of various kinds I have developed a Two Fold formula when it comes to my own stock picking. All you have to to read it is subscribe to my free newsletter.