Island Investing: Focused Portfolios

Q. How many stocks should I own?

A. I’d like to clarify two points for new readers. The first is that I believe that the majority of long-term investors are best served by investing in an index fund – a widely diversified, passively managed fund built just to match the performance of the whole stock market.

The second point is that if you’re going to build a focused portfolio containing a limited number of stocks, you either have to really know what you’re doing or find someone that does. One of my favorite quotes sums this up well: “Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot.”

My own beliefs about diversification are the opposite of conventional Wall Street wisdom. In short, while diversification can play an important role in protecting overall wealth, I believe it is of limited use when you are trying to really grow a specific portion of your assets. It is simply a mathematical fact that the more stocks you own in your portfolio, the lower the odds are that you’ll be able to outperform an index fund.

In addition, putting your money to work in your best ideas also just makes more intuitive sense to me. If you own four stocks and one increases by 50% while the rest stay flat, your total portfolio will gain 12.5%. If you own 100 stocks and one increases by 100%, your portfolio is only up 1%. Why put money in your 76th best idea?

I believe you can reduce risk by deeply understanding the companies you invest in, as well as knowing their real value, not by spreading the risk across more companies. I see danger in owning too many investments because it becomes too hard to closely follow the progress of too many businesses.

So you probably don’t need to know more than a dozen companies really well over the course of your life to become wealthy. But you do have to know them very well.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.
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