Excerpted from How to Make Money in Stocks, 4th Edition, by William J. O’Neil.
Once you have decided to participate in the stock market, you are faced with more decisions than just which stock to purchase. You have to decide how you will handle your portfolio, how many stocks you should buy, what types of actions you will take, and what types of investments are better left alone. This will introduce you to the many options and alluring diversions you have at your disposal. Some of them are beneficial and worthy of your attention, but many others are overly risky, extremely complicated, or unnecessarily distracting and less rewarding.
Regardless, it helps to be informed and to know as much about the investing business as possible—if for no other reason than to know all the things you should avoid. I say don’t make it too complicated; keep it simple.
How Many Stocks Should You Really Own?
How many times have you been told, “Don’t put all your eggs in one basket”? On the surface, this sounds like good advice, but my experience is that few people do more than one or two things exceedingly well. Those who are jacks-of-all-trades and masters of none are rarely dramatically successful in any field, including investing. Did all the esoteric derivatives help or harm Wall Street pros? Did experimenting with highly abnormal leverage of 50 or 100 to 1 help or hurt them?
Would you go to a dentist who did a little engineering or cabinetmaking on the side and who, on weekends, wrote music and worked as an auto mechanic, plumber, and accountant?
This is true of companies as well as people. The best example of diversification in the corporate world is the conglomerate. Most large conglomerates do not do well. They’re too big, too inefficient, and too spread out over too many businesses to focus effectively and grow profitably. Whatever happened to Jimmy Ling and Ling-Temco-Vought or to Gulf+Western Industries after the conglomerate craze of the late 1960s collapsed? Big business and big government in America can both become inefficient, make many mistakes, and create nearly as many big new problems as they hope to solve.
Do you remember when Mobil Oil diversified into the retail business by acquiring Montgomery Ward, the struggling national department-store chain, years ago? It never worked. Neither did Sears, Roebuck’s move into financial services with the purchases of Dean Witter and Coldwell Banker, or General Motors’s takeover of computer-services giant EDS, or hundreds of other corporate diversification attempts. How many different businesses and types of loans was New York’s Citigroup involved in from 2000 to 2008?
The more you diversify, the less you know about any one area. Many investors over-diversify. The best results are usually achieved through concentration, by putting your eggs in a few baskets that you know well and watching them very carefully. Did broad diversification protect your portfolio in the 2000 break or in 2008? The more stocks you own, the slower you may be to react and take selling action to raise sufficient cash when a serious bear market begins, because of a false sense of security. When major market tops occur, you should sell, get off margin if you use borrowed money, and raise at least some cash. Otherwise, you’ll give back most of your gains.
The winning investor’s objective should be to have one or two big winners rather than dozens of very small profits. It’s much better to have a number of small losses and a few very big profits. Broad diversification is plainly and simply often a hedge for ignorance. Did all the banks from 1997 to 2007 that bought packages containing 5,000 widely diversified different real estate loans that had the implied backing of the government and were labeled triple A protect and grow their investments?
Most people with $20,000 to $200,000 to invest should consider limiting themselves to four or five carefully chosen stocks they know and understand. Once you own five stocks and a tempting situation comes along that you want to buy, you should muster the discipline to sell your least attractive investment. If you have $5,000 to $20,000 to invest, three stocks might be a reasonable maximum. A $3,000 account could be confined to two equities.
Keep things manageable. The more stocks you own, the harder it is to keep track of all of them. Even investors with portfolios of more than a million dollars need not own more than six or seven well-selected securities. If you’re uncomfortable and nervous with only six or seven, then own ten. But owning 30 or 40 could be a problem. The big money is made by concentration, provided you use sound buy and sell rules along with realistic general market rules. And there certainly is no rule that says that a 50-stock portfolio can’t go down 50% or more.