Ask Mike:
What is the ideal number of stocks to have in a $30,000 portfolio?

Question:

Hi Mike,

I am just getting started in the stock market and have what is likely to be a very remedial question:

What is the ideal number of stocks to have in a $30,000 portfolio?

Thanks in advance,

JJ from Madison, WI

Mike's Response:

Hello JJ,

Actually, this is not a remedial question. You would be surprised to learn how many long-time, seasoned investors don't really know the answer to that question.

Some would say it is just an arbitrary number. They might say you should invest in as many companies as you can adequately stay on top of... others would say you shouldn't have more than 4 or 5 positions.

As you might expect, I actually have a formula or process for determining the maximum number of positions you should have in a portfolio, regardless of the amount of money you have to invest.

The most important consideration is risk versus reward. You should make a decision about how much return you think is reasonable for you to make each year. If your answer is 4% or 5%, then just put your money into a Money Market and don't worry about it. Your risk is minimal and your reward is low.

The higher your desired return, the more risk you are going to have to take. Let's say you want to make 15% per year. Ok.. there are a few stocks out there that pay 15% or more in annual dividends. The problem is these companies don't always pay and, many of them have very poor fundamentals. So, you could just buy into stocks that supposedly pay a 15% yield, but now your risk is very high I think the risk is too high for the potential return.

So, let's assume you have decided to settle on a 15% return, but want to only buy high-quality, growth/income stocks. This is a good and reasonable objective.

You could do your research and find that one, special stock, that you believe will generate a 15% return on your investment. But, even an investor newbie knows that to put all of your investment into a single stock is very, very risky. Betting everything on a single stock just doesn't make sense and, of course, you know that.

To reduce your risk, you will need more than one stock in your portfolio. But, just adding more stocks to your portfolio does not, by itself, decrease your risk. Indeed, it could INCREASE your risk. For example, six months ago, you could have owned 10 or more homebuilding stocks. They had been on fire for years. But, over the past 6 months, many of those companies have lost more than 30% of their share price. If your goal had been to make 15%, you would have missed that goal by 45% by investing just in homebuilding stocks.

As you grow your portfolio by adding more (I'll get to the magic number in a moment) positions, those positions should be from disparate Industries and/or Sectors. I, personally, will hold no more than 30% of my portfolio in any one Sector and nor more than 20% in any one Industry.

The next thing you should consider is the net cost of trades. For the moment, forget about the total number of positions... just think about the number of trades you will make each week or each month or each year. In other words, how many times will you be buying and selling?

In my opinion, you should not be spending more than 2% of your total investment for trading fees. Using your investment basis of $30,000, that would be $600. For sake of discussion, let's assume you are paying $10 per trade. That means you can only make 60 trades in a year to stay at 2% or less in trading fees. But, don't forget that a trade generally means you will be buying AND selling. The 60 trades includes BOTH your buys and your sells.

You might be wondering why I selected 2% as your maximum cost for trades... I look at trading fees as the hurdle I have to get over before I can really consider my rate of return. I want that hurdle to be as low as I can get it. Using the example above, let's say you had 120 trades per year... that means you have to earn 4% just to break even... double that number of trades to 240 and you have to earn 8% just to break even.

Matching the number of trades with your investment basis is a critical calculation. To overlook this calculation can make all your hard work amount to nothing. For example, suppose it was a bad year in the market and you only made 6%, but spent 2% on trades. You took a lot of risk for that net 4%... you could have just put your money into a Money Market or T-Bill and made your 4% (or more) with zero risk.

Ok... now to figuring out how many positions to hold in your portfolio...

You should hold as many as you can and keep your trading fees at 2% or less. The operative part of that last sentence is 'as you can'. You should never buy shares of any security without knowing what you are buying. This means you have to do some research, or hire someone to do the research for you (i.e., use an advisory service or financial advisor that you trust and has a good track record.)

For a $30,000 portfolio, you should be able to hold 10 positions and keep your trading costs at or below 2% assuming you have enough time to study and trade those 10 positions throughout the course of a year.

Also, I consider 10 positions a minimum number of positions that you can hold to maintain decent diversification.

Thanks for the question, JJ.

Regards,

Mike