Listen to the Podcast
Subscribe to the podcastiTunes Stitcher
Hey, this is Sasha Evdakov and thanks for joining me here for another lesson about trading and investing.
Today what I'd like to do is share with you my insights about the number of stocks to trade or watch at any given time.
I get this question quite a lot. People wondering something like this:
- Shouldn't I diversify?
- How many stocks do I need to have in my portfolio?
- Do I need to protect myself for a downside move?
And I'm going to answer this question in this video. Let's take a look and get going.
Useful Quotes You Need to Apply
Before we get too deep in the lesson, I do want to share with you a few quotes from the great traders.
"It is much easier to watch a few than many."
This quote was by Jesse Livermore. In other words, if you haven't had a chance to read the book then go for it. It's classic.
Here's another quote:
"Don't buy too many different securities. Better have only a few investments which can be watched."
This one was by Bernard Baruch.
And then the last quote is:
"Keep the number of stocks you own to a controllable number. It's hard to herd cats, and it's hard to track a lot of securities."
This one again was by Livermore. He said quite a lot of wise things in his days.
The Modern Problem of Diversification
People are looking to diversify to hedge or split up their positions in case things go wrong. Now when you look at diversification, the common consensus is that you have to diversify. You should diversify, you need to have multiple stocks. At least 5-7 stocks, then we'll also check if you are diversified enough.
Overall if you're looking at things you should be diversifying between not just stocks and assets you should all be diversifying in things like real estate and business holdings.
But the majority concentrate on one oil company, one telecom, one tech company, one consumer staples or financial company. Are you diversified enough in your portfolios if in case you get a lousy rack within tech at least your financials or telecom can hold you up?
That's the main point and why a lot of people are focusing on diversification. Now most people who start trading don't have enough money to diversify. That's the modern problem of diversification. They're trading a small account relative to how large or how big the stock market is.
You have to remember that the more positions you have, the more difficult it is to fix them if something does go against you. That's ultimately the other issue. Is that as you keep diversifying further and segmenting things and you have 10-20 positions on it, it takes a lot longer to adjust if something goes against you.
Maybe you're the type of person that's going to let your stock sit and rock for the next 10 or 20 years. And I think having 3-5 positions might be a good thing because ultimately that's what diversification is all about.
If one thing goes wrong at least, you have the next idea or another investment to keep you moving forward.
The first scenario:
If you're entirely hands-off investor where for 20 years you don't want to look at you might be better off with a target date fund or retirement fund. That's better in that case.
It just makes things a lot easier — something like a simple ETF that's diversified on its own.
The second scenario:
You're an active investor and you're looking to increase the number of positions that you have to diversify against the down move.
Let me share with you why it's not always a great idea. It's not because I find that too many people (especially at the beginning stages) have this concept of I have to diversify.
Example of Over-Diversification
I need to diversify so much to the point where they have over diversification than what they should.
Here's a quick example. What I want to share with you is if something goes wrong and pretend each one of these paper clips here that I have laid out on the table is a stock that you have ownership.
You have all these positions laid out on the table (on the stock market). Your goal is when something hits the fan if there's a significant problem you need to adjust at least more than half. But it's better to make adjustments to all.
Let's say there's a significant issue and you have to adjust. Because you are an active investor. Again I'm not talking about the person that's holding things for twenty years. This is for a person that's adjusting, looking at things, fixing their portfolio, and tweaking things.
Look at how long it takes me to go ahead and make adjustments to new positions. Even if I'm doing it in a big batch, it takes a while to adjust these positions.
I have to evaluate them and make an adjustment. Then if the market keeps heading lower, recheck my current position, and then finally, I have everything fixed.
It takes quite a bit of time. If you had a couple of positions (let's say four positions) to make those adjustments and fix them, it takes no time at all. It's a lot quicker.
That's where you want to get to. You want to make things as simple as possible. Keep in mind the purpose of diversification. It is there to reduce your risk when the market goes against you. That's the whole point behind it. However, most people have a long-only position, and that is the reason why they have that diversification.
If you are more active, you'll have a mixed portfolio that includes long positions in short position. It may be even me option hedge positions, and you'll need a lot less diversification. But, yes, the typical mindset is to have more diversification because most people are only investing on the long side of stocks.
They don't have short positions, they don't have option trades to hedge in their position, or they don't know how to reduce and adjust their risk.
In that case, yes, this is why the diversification mindset constantly gets pumped in our mind. Now I'll give you some insights about your account size and some guidelines of how many positions to have.
It's important to keep in mind this will change from person to person. It depends on your situation of how you like to manage things.
One of The Possible Situations
Let's say if you're under $75,000 on your total portfolio or investment side you'll want less than three equities or three vehicles, which means 3 positions in total. Three stocks if you're trading stocks.
If you have under $500,000, you'll want less than four equities or four stock positions. Let me think about it this way. If you're investing in Amazon right now and you had 500 shares because it's almost a $1000 a share - that's $500,000.
Only need a hundred shares of Amazon, and already that's just one equity. Think of it that way. If you're trading higher grade value stocks, you don't need a ton of position. The handful of shares in Apple, Microsoft or Exxon Mobil and you're at $500,000. Or even $1,000,000. Even then at that point, less than five positions is pretty much all you need.
And as you continue to grow your account even $1,000,000 to $10,000,000 depends on your management. If you have a team of people, you may want to go with a few more positions. But if you're managing your account, you want to stay (even if you're trading a 10-20 million dollar account) under 5-6 positions.
I'd say five positions at most because the management side of it is just more problematic. What you don't want to happen is when you have so many positions loaded up you're not focused.
You're cluttered all over the place, and instead, it's better to pick a few. Three to four right positions and then put your money into those stocks. Allow those stocks to accelerate and grow rather than having one to two hundred crummy positions.
I'd instead take a $1,000,000 and put it in two or three stocks that are going to grow exponentially. It's better than having a couple of hundred stocks where they might make a little here and there.
But if the market turns, I would have to fix all those crummy positions because the stocks and the companies are not strong enough to sustain a market that moves against me.
Instead, a better approach is to mix up your portfolio. Change things around; don't just have a long-only position. Have a mix back, have some long, have some short and throw in a few option trades in there. But ultimately that's what you want to do.
Otherwise, if you're trying to over-diversify, it becomes a management nightmare. When things go against you, you are going to take a considerable toll.
Not only in commissions, but also in managing those positions and fixing them when you need to hedge, adjust or counterbalance them for the other direction.
Example of a Diversified Portfolio
I want to show you a diversified portfolio with not a lot of positions.
If we're looking at buying five different positions, I could look at McDonald's. I go with 100 shares for now. Analyze the trade. This is what typically most people's portfolio looks like.
It's looking for the upside. This is your profit picture and then on the bottom here is the stock price. Then here is your profit and then here is your loss - that is your zero lines.
As the stock moves, they're making a profit. You can see if it goes to 160 and McDonald's with 100 shares I make about $541. In either case, what happens is then people will go to ExxonMobil, and we'll buy another hundred shares. I've done a change from a Single Symbol to a Portfolio Beta Weighted.
It continues to stack more positions for me in the upward direction. That's not necessarily healthy, so you may want to do something TLT or the bond. Sometimes this can be better because the bonds usually will move up as stocks go down.
It can give you more insights. There's a bond TLT right here. Now I'm hedging or basing it based on TLT. If I did it by ExxonMobil, you could see I'm overall still looking for prices to hat higher.
You could slowly start diversifying in this way, but the overall portfolio is still to the upside. Instead, a better approach might be too short of a certain amount of shares on McDonald's.
Let's say 70 shares. Now I have McDonald's that 70 shares short. I have TLT bonds that 50 to the upside, and then I also have ExxonMobil. If you pair that with some option contracts you'll have a relatively nice rounded portfolio or a variation.
Maybe you want another MAT, and you want to short this one. I'll go ahead and sell, analyze the trade rather than 500 shares. You can see the more I stack if I buy some, I'm a flatline on some positions.
You can see that I can flatten this curve out. That way, as things had higher, it doesn't affect me too much. But I have multiple positions. I have a MAT, McDonald's, TLT and the Exxon Mobile.
I'm shorting the McDonald's, and then I have much more of MAT. Now you could short MAT, a hundred shares. Let's say we baked it again based on ExxonMobil. Now I have MAT a hundred shares short, McDonald's 70 shares short. ExxonMobil you do 200 shares, or you could do 100 shares and 150 on the TLT, or a hundred shares on the TLT.
It gives you a nice little mix. Now you're a bit short here. Overall you want prices to go down when you're looking at it. But you can adjust this. You can get rid of the MAT or increase your TLT and ExxonMobil. That way if you do have a few short positions. It's only one or two short positions, and the majority of it is still long.
And there you go, there are four positions. You could add in an SPX (let's say a calendar). You can buy a calendar and analyze the trade, and we'll go from July to August.
Your portfolio is going to look a little bit different. That's because as you have the stock positions, you can see that profit picture.
It's more the upside. But as you add a calendar, you can see you still have that curvature in that calendar a little to the upside.
You can see it's almost like turned a little bit. That's what option trading allows you to do. Now you could stack more contracts, or you could go to a smaller embassy to make a little adjustment. But that's what you're doing. You're mixing things up to diversify, and you don't want to go with 10-20 different positions.
Because as you start stacking more and more of this, it just becomes problematic when things do go against you. When the market explodes either will be upside or the downside. You have many positions writing. It only becomes a management nightmare.
Keep things simple. Make it simple, not only for your management side but also for your mental sake and your own life. Once you get to 4-5 position all you got to do is hit this plus button then you increase the share amount.
Exxon Mobil Example
If I wanted to increase ExxonMobil for 1000 shares (confirm and send) and that's already $80,000 worth of position.
It's already $100,000. You can do a thousand on ExxonMobil and even two thousand or 1500. That stock is liquid. I could do the same with Amazon and Apple, and there you go there are a million bucks. A million dollars in the stock market is not that much money when you're talking about multi-billion dollar companies.
Keep things simple as far as the management goes just for your sanity. Because the diversification does help, but you don't need to be over-diversified.
Be very careful in that spectrum because most people go way beyond it especially if you are active if you are watching your stocks, if you're paying attention to what the market is doing.
Couple stocks to three positions on your stocks. That's all you need. Get the ones that are moving the fastest and the shortest amount of time.