Right number of stocks in a portfolio

 Theory

 

The father of the Modern Portfolio Theory is the American economist Harry Markowitz. Markowitz outlined the theory in a paper called ‘Portfolio Selection’, published in March 1952 in The Journal of Finance.

MPT assumes that investors are risk-averse and seek to maximize returns while minimizing risk. It provides a mathematical framework for determining the ideal mix of assets that will provide the highest expected return for a given level of risk or the lowest risk for a given level of expected return.

The Modern Portfolio Theory focuses on the relationship between assets in a portfolio in addition to the individual risk that each asset carries. It exploits the fact that a negatively correlated asset offsets losses that are incurred on another asset. For example, Crude Oil prices  and airline stock prices are negatively correlated.

If something happens in social media space and some internet startups like Facebook or LinkedIn, it's probably going to have very little impact on what's happening in the oil sector globally. Those are going to be pretty uncorrelated. Also, another uncorrelated sector example is going to be gold stocks and technology.

Modern Portfolio Theory (MPT) the investment framework developed by economist Harry Markowitz in the 1950s provides a way to optimize investment portfolios by balancing risk and return. MPT suggests that by diversifying investments across different asset classes, an investor can achieve a higher level of return for a given level of risk or minimize risk for a desired level of return.

There are two types of risks in investment in a security. Unsystematic risk is a risk specific to a company or industry, while systematic risk is the risk tied to the broader market—which is why it's also referred to as market risk. Systematic risk is attributed to broad market factors and is the investment portfolio risk that is not based on individual investments.  Systematic risk, also known as market risk, cannot be reduced by diversification within the stock market. Sources of systematic risk include: inflation, interest rates, war, recessions, currency changes, market crashes and downturns plus recessions. Because the stock market is unpredictable, systematic risk always exists.

The Illusion of Diversification

 

It has long been known that diversification can help reduce one's portfolio risk while also boosting returns. Just how many stocks are enough to achieve a properly diversified portfolio—maximum diversification—has been a subject of research and debate

In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of Variability of Returns on Investments in Common Stocks” published in The Journal Of Business on the "reduction of return scattering" as a result of the number of stocks in a portfolio. They found that a randomly created portfolio of 32 stocks could reduce the ‘return distribution’ by 95%, compared to a portfolio of the entire New York Stock Exchange

Increasing the number of stocks always reduces portfolio volatility in this model. This is the power of stock diversification. The question is when has volatility been reduced enough such that the marginal benefit of an additional holding is immaterial. Most studies use the fully diversified portfolio as a benchmark and then derive that a portfolio of 20-30 stocks achieves a 'similar' risk profile as the target portfolio.

Most research on portfolio management suggests the right number of stocks to hold in a diversified portfolio is 25 to 30 companies. Owning significantly fewer is considered speculation and any more is over-diversification.

Practice

According to investment experts, one should have fair allocation of amount against each stocks while making one's stock portfolio. This helps an investor's absolute investment to grow at a rapid speed. One should create stock portfolio allocating at least ₹50,000 to each stock in a stock portfolio with an absolute value of ₹5 lakh. However, with the pass of time, one can increase fund allocation against each stock or add some more stocks in portfolio because good number of public issues are getting listed these days. Later on, one can add more money against their selected stocks. Likewise, they can add more stocks in one's portfolio as a good number of public issues are getting listed on Dalal Street these days. However, he maintained that number of stocks should not go beyond 15 in one's stock portfolio. But, when total number of stocks are 15 in your portfolio, then there should be at least ₹1 lakh amount against each share.

While creating one's stock portfolio, one has to keep in mind that purpose of this exercise is to generate alpha return against equity mutual funds. So, while allocating funds to one's stock portfolio, one needs to remain vigilant about this investment goal and choose stocks accordingly. One should keep fair amount against each stock so that it give compounding benefit on one's return over the time. At the same time, rise in stock price should reflect in one's stock portfolio return as well. So, proper fund allocation is also an important factor that one can't afford to ignore while selecting stocks for one's portfolio

There is no perfect answer to this, but it all boils down to what one can study and track diligently. The ideal number which one can track while pursuing his other jobs & responsibilities simultaneously is 10-12 stocks. This number can be high if you are into stock trading as a profession or could be low if your daily job is too demanding and doesn’t leave you with enough time for research

Stock portfolio which is limited to 4-5 stocks can be hugely concentrated and again if your conviction or research is not spot-on, it could lead to increased volatility and risk adding, "Ideally, limiting a portfolio to 10-12 stocks will give you reasonable diversification and ample time to be able to track the news flow

Large-cap vs mid-cap vs small-cap stocks

When allocable budget is large enough, as a rule of thumb, one may allocate 25 per cent fund to large-caps and rest to mid-cap and small-caps as money comes from mid-cap and large-cap stocks in long term. However, proper research of stocks before investing and if needed one should not shy of taking advise from an expert.