Puzzle Pieces.

During the holiday season my family and I like to put together a puzzle or two.  It has become a holiday tradition in our humble home.    When my daughter was young the puzzles were simple and easy to manage.  As she grew older the puzzles became more complex with thousands of pieces.  Each puzzle size has its pros and cons.   The smaller puzzles were easy to assemble but if we lost a piece or two it didn’t look like much of a puzzle when finished.   The larger puzzles took us a few days to complete and it didn’t matter if we lost a couple of pieces because we still had close to 1,000 pieces.  

The Morningstar database currently tracks 109,000 global stocks.   Can you imagine trying to put together a 100,000-piece puzzle?   The largest puzzle I found has 24,000 pieces.[1]

When constructing your investment portfolio how do you pick the best stocks from the 109,000 publicly traded companies?  Dividend?  PE? Earnings? Price?  Of course, the stocks you choose will depend on the amount of money you’re going to invest.

Let’s say your investment capital is $50,000 and you decide to invest $5,000 into each company.   In this scenario, you’ll be able to purchase ten stocks.   Of the 109,000 stocks in the Morningstar database, how will you choose the ten best?  The ten companies you pick represent .0001% of the stocks in the database.   And what do you know that Warren Buffett, Peter Lynch and David Swensen don’t know?

Let’s up your investment capital to $500,000.  You decide to keep your individual stock investment to $5,000 for diversification purposes.  You know own 100 companies.  You should be able to achieve a balanced portfolio with 100 companies.  You’ve achieved diversification but how do you follow 100 companies?  Do you have the time, interest, discipline, and emotion to keep tabs on your growing portfolio?

How about a portfolio of $5 million?   Even though your account has grown you still want to invest $5,000 into each company.  You now own 1,000 stocks.   If you own 1,000 stocks, it better be your full-time job!  The reality is as your account grows so too will your position limits.   In an account of this size, you’ll probably invest between $100,000 and $200,000 into each company.

How many stocks do you need to own to achieve portfolio diversification?  10? 25? 100? 400?  A study by the American Association of Individual Investors suggests a portfolio north of 400 stocks.  Owning 400 stocks can reduce your diversifiable risk by 95%.[2]   Dimensional Fund Advisors recommends owning 11,000 stocks to achieve diversification bliss.[3]

What to do?  How can you achieve diversification?  Here are two thoughts.

1.       Buy a lot of stocks.  You can, of course, buy as many stocks as you want.  I once worked with an advisor who would purchase 1 to 2 shares of a company.  He owned a sliver of hundreds of stocks.  I never understood his investment “strategy.”   Jim Cramer suggests owning between five and ten companies and committing an hour of research for each stock owned.[4]  In Mr. Cramer’s model if you own 100 companies, you should commit 100 hours to research.

2.       Purchase stock index mutual funds.   A portfolio of index funds will allow you to own hundreds, if not thousands, of companies.  The advantage to owning index funds is you can achieve diversification at a low cost.  With a purchase of four, five or ten index funds you can also simplify your financial life.  It’s much easier to follow a few funds when compared to tracking thousands of companies.

There are many roads to financial success so travel one that makes sense for you and your family.   The goal should be to grow your wealth so you can support your family’s lifestyle.

It’s not about the pieces, it’s how they fit together. ~ Anonymous.

Bill Parrott is the President and CEO of Parrott Wealth Management.  www.parrottwealth.com.

November 1, 2016

Note: Past performance does not guarantee future results.
 

[1] http://www.worldslargestpuzzle.com/, accessed October 31, 2016

[2] http://www.aaii.com/journal/article/how-many-stocks-do-you-need-to-be-di..., AAII Journal by Daniel J. Burnside, July 2004

[3] https://my.dimensional.com/insight/purely_academic/23691/, Effective Diversification and the Number of Stocks by Jim Davis, 9/26/2008.

[4] http://www.cnbc.com/id/100765791, Lee Brodie, 10/7/2014, Stocks, How Many is too Many?