As a follow-up to a previous question, I’d like to discuss how many stocks we should hold in our portfolio.
No Universal Number for Stocks
There isn’t a specific number of stocks that is universally appropriate. Instead, we should approach this issue by considering risk and return factors. First, we need to think about individual versus systemic risk, and then we can look at the potential gains.
Correlation Among Stocks
One key point to clarify: the original question assumes we only hold stocks. However, stocks are highly correlated, especially during crises when correlations tend to increase. Even the lowest beta for a stock portfolio is usually between 0.30 to 0.50, indicating some correlation with the broader market. This means that by holding only stocks, we’re exposed to systemic risk, and we need strategies to mitigate it.
Diversifying Beyond Stocks
One of the most effective ways to reduce this risk is to diversify across different asset classes rather than solely holding stocks. This is what many Commodity Trading Advisors (CTAs) do, trading between 50 to 150 different markets.
The Key Question: Diversifying Across Markets
So, the more accurate question is: How many different markets and asset types should we include in our portfolio to effectively reduce systemic risk?
Overnight Risk Considerations
Let’s start by talking about overnight risk. There’s always a chance that a market opens significantly lower than it closed. For instance, an asset might open 20% down overnight. In this case, there’s no opportunity to sell during the decline—you’re immediately exposed to the full loss. That’s why I believe it’s wise not to allocate more than 10% of your capital to any single asset.
Day Trading vs. Overnight Exposure
Some might suggest day trading as a solution, exiting positions at the close to avoid overnight risk. However, there could be legal, logistical, or personal reasons that prevent this. For example, you might not want to sit in front of your computer all day. Additionally, much of the value appreciation in assets occurs overnight, meaning day traders often miss out on these gains.
Risk Per Trade: Key to Portfolio Size
Another important factor is determining how much risk we’re willing to take per trade. Let’s say you have $100 and want to limit your risk to 0.1% per trade. If the asset you’re trading has a 5% volatility, you can only allocate $2 to that trade based on volatility-adjusted risk management. If you’re willing to take 0.5% risk per trade, you could allocate $10 instead.
Using these examples, if you take 0.1% risk, you could manage 50 different assets (100/2 = 50), but if you take 0.5% risk, you’d be able to trade only 10 assets (100/10 = 10). This shows how your individual risk tolerance directly influences the number of assets you can hold or trade.
Managing Systemic Risk with More Assets
However, we also need to consider systemic risk. Trading a limited number of assets concentrates this risk. To mitigate systemic risk, we should aim to increase the number of assets that are uncorrelated, thus diversifying the portfolio more effectively.
The Caveat: Lower-Yielding Assets
One caveat to increasing diversification is that it can lead to allocating funds to lower-yielding assets, which may reduce overall profits. For example, if stocks increase by 20% but coffee futures remain flat, adding coffee to the portfolio would reduce systemic risk but also dilute potential gains. Some argue that diversifying increases alpha over the long run, but to me, this is more about hedging rather than generating alpha.
Balancing Profit and Diversification
We also need to look at diversification from the perspective of maximizing profits. As mentioned earlier, excessive diversification spreads capital across low-yield assets, reducing potential returns. Ideally, we want diversification that includes assets with both low correlation to the stock market and high potential returns.
Risk Tolerance and Asset Allocation
This principle also applies to individual asset risks. Returning to the earlier example: in the second scenario, you need to trade 10 assets with a higher risk appetite, but this increases to 50 assets in the first scenario with lower risk tolerance. Lower risk tolerance means allocating smaller amounts to each trade, requiring more trades to achieve the same level of diversification.
For instance, you might want to allocate $10 to a high-volatility tech stock like Nvidia, which could offer higher returns. But if your risk tolerance forces you to allocate only $2 to Nvidia, you’ll need to invest the remaining $8 elsewhere, potentially in assets that generate lower returns.
Conclusion: Balancing Diversification and Concentration
In conclusion, we need to find the right balance between diversification and concentration. Over-diversifying can reduce profits, while under-diversifying exposes us to the risk of ruin. The goal is to strike a balance—diversifying enough to manage risk without sacrificing too much potential return.