How Many Stocks Should Be In Your Portfolio? (Buffett, Lynch, Pabrai Explain)

We think diversification is a practice that generally makes very little sense for anyone that knows what they're doing. Uh, diversification is a protection against ignorance. [Music] This video is sponsored by Hypercharts. Sign up to Hypercharts using the referral code NEW MONEY or use the referral link in the description and save 10% for your first year of Hypercharts Premium. Details in the description.

Well, diversification—hey, what seems like a pretty basic topic—turns out is actually really controversial. Half the investing world screams you have to diversify; you know, if you don't, you're taking a huge risk. Please spread your money; don’t have all your eggs in one basket! Then the other half of the investing world says, “No, don’t diversify! You only need a few stocks that you know really well, and if you diversify, you just end up buying heaps of mediocre companies.”

So in this video, what we're going to be doing is listening to the perspectives of three great investors: Warren Buffett, Peter Lynch, and Monish Pabrai—to see what they think of diversification, and from that, we'll try to figure out how many stocks we should be holding in our portfolios. So with that said, let’s start with Peter Lynch and his very strong thoughts on portfolio diversification.

“I don’t believe in diversification at all. I would own one stock if I could find one great stock. Diversification is a big mistake. I call it diversification, but you buy this thing that might balance this other thing, and they both go down. So I don’t believe in diversification at all. I would own one stock, but what I do believe in is if I find ten good stories that are all equally attractive, I buy all ten and I wait to see them unfold. It’s like watching ten poker games—ten games of stud poker. You watch the cards turn over. Story three gets better, story six slips, story seven stays the same, but it goes up fifty percent. So you sell seven and buy two; that’s all I do. So if they’re equally attractive, I buy all ten. Then gradually, some story says, ‘Oh my God, this is getting better and better,’ and guess what? The stock just went down. So you keep watching ten stories, and magically, because of that rule of stocks going up and down a lot, then you load up. You really take a big advantage. So that either happens to be something that happens to the company, or the market goes down, and all stocks go down.”

So Peter Lynch is clearly quite against diversification, calling it a big mistake. You know, he’s happy to own just one stock if that's all he can find at the time. Interestingly, he does note that if he finds ten great stories, he'll buy all ten. He won't sweat; he’ll definitely buy all of them. But then, he also says he’ll eventually find one of those stories that just gets more attractive than the others, and he’ll just load up on that. So he won’t care about that one stock occupying a much, much higher percentage of his portfolio.

And in all honesty, I actually agree a lot with Peter Lynch. I think largely diversification for the sake of diversification is a big mistake. You know, if you’ve only got one good option at the time, don’t buy one good company and nine average ones; just buy the one good one. But I think there’s something that Peter Lynch misses in this clip, which Buffett highlights in this next clip.

So let's have a look. “We think diversification is a practice that generally makes very little sense for anyone that knows what they’re doing. The diversification is a protection against ignorance. I mean, if you want to make sure that nothing bad happens to you relative to the market, you own everything. There’s nothing wrong with that. I mean, that is a perfectly sound approach for somebody who does not feel they know how to analyze businesses. If you know how to analyze businesses and value businesses, it’s crazy to own 50 stocks or 40 stocks or 30 stocks probably, because there aren’t that many wonderful businesses that are understandable to a single human being in all likelihood. And to have some super wonderful business and then putting money in number 30 or 35 on your list of attractiveness and forego putting more money into number one just strikes Charlie and me as madness.”

It must be said Buffett's thoughts are pretty well aligned with Peter Lynch here. Diversification is protection against ignorance, but Buffett adds an important point, and that is to meet the requirement of completely understanding the business you invest in—you actually can't diversify that much. As an investor, you've got limited brain power and limited time. I can tell you from experience that there’s no way you're going to be able to keep up with 50 companies in depth. No way. There aren’t enough hours in the week. That’s 50 hours' worth of earnings calls alone that you have to listen to every single quarter.

Quite simply, if you had 50 stocks, there’s just no way you’d know anywhere near enough about each one of those companies to be confidently invested in them. But then there’s a second crucial point Buffett adds in this clip that usually people forget, and this is what I was referring to before—the thing that Peter Lynch missed. When Buffett says diversification is protection against ignorance, that sounds like a dig at people, “You know, you’re just a silly ignorant investor,” but it really isn’t. Notice he follows up by saying there’s nothing wrong with that. That is a perfectly sound approach for somebody who does not feel they know how to analyze businesses.

So while Peter Lynch just said, “No, diversification is silly, full stop,” Buffett really breaks it down. If you’re an active investor and selecting the stocks you invest in, then diversification makes little sense. But on the other hand, if you’re a passive investor that just wants to get the average market return, then yes, diversify; own everything. And remember, passive investing is the most popular strategy in the world. If you follow that approach, then ignorance is your superpower. It’s nothing to be ashamed of. Go outside and scream, “I have no idea what’s going on in the market right now,” and be proud of it! You know, chances are with this approach you’ll do better than most other people trying to buy individual stocks.

So I’m glad that Buffett covered this, and this is very much my viewpoint on diversification—for active investors, no; but for passive investors, yes. But now let’s hear from Monish Pabrai. Let’s hear him sum it all up and add one more layer onto this diversification argument.

“If you look at most entrepreneurs, they don’t even have four bets. 98% of their assets is one bet, and they don’t have sleepless nights. You know, they’re pretty comfortable with a single bet and a lot of the eggs in one basket. So I think that if you know what you’re doing—well, if you don’t know what you’re doing, please index. It's a pretty honorable way to go through life, and you still get the power of compounding. But if you know what you’re doing, then it seems like insanity to own 30 stocks or even 20 stocks. I mean, why would you put money, like Buffett would say, why would you put money into your 27th best idea instead of your third best idea? You know, so that just makes no sense. And the idea that you would actually understand 27 businesses as well as each of them—or equally—is unlikely. So there are circle of competence issues; there’s a depth of understanding issues that come in. And so, for my point of view, the answer has been, at least in corporate funds, to go with like a 10 by 10 portfolio—10 stocks, 10% each—it seems like a good medium. In my personal portfolio, sometimes I’ve had one stock, you know, and I don’t think I’ve had many occasions when there’s been more than four or five positions.”

I like this clip from Monish because it just ties everything together so well. Honestly, Monish, for me, just has a way of explaining things that seems to click. I don’t know if you guys get that as well, but I just find his explanations really, really helpful. But he’s totally right! He takes the approach that, you know, think about the entrepreneurs of the world—the people that are running businesses. Don’t just think about stock market investors. I mean, those people, they usually have everything they’ve got in their business, and that doesn’t stress them out and keep them up at night. You know, someone you may know might have a business. You know, you might have a business where pretty much all of your eggs are practically in that one basket, but you probably don’t feel like you need to sell your business tomorrow to buy a little stake in lots of other businesses, right? Just to spread your risk.

No. Then from there, Monish goes on to cover the same points that we’ve already touched on—mainly that number one: the more stocks in your portfolio, the more questions there are about your depth of understanding of each business. That was definitely Warren Buffett’s point. But here’s a really interesting point that we haven’t discussed yet. Two: if you’re an active investor, why would you put any money into your 30th best idea? Why not just put more into your best idea? If you hold 30 stocks and list them in order of how much you like the business, number 30 is going to be significantly worse than number one. So imagine this: Imagine I gave you a thousand dollars, and I say here are 30 companies listed in order of how well they’re doing. You can either put a thousand dollars into the best performing, or you can put a thousand dollars into the 30th best performing company on that list—where are you gonna put your money? I certainly know where I’m putting it.

Now, an interesting side note too is that Monish does actually say that his fund is diversified, following a loose rule of 10 stocks, each holding about 10% of the portfolio. But this actually doesn’t surprise me here, because it’s one thing to invest your own money, but it’s a completely different ball game to invest other people’s money. So some diversification—obviously not a lot, but some diversification—I think in these funds is a good idea, just to make sure you aren’t left potentially exposed to the tiny chance of some unforeseen calamity that just absolutely sinks the portfolios of, say, your friends and family. That wouldn’t feel great if it happened.

But generally, I think if you’re just investing your own money, you really don’t need to feel any pressure to hold any certain number of stocks, provided you knew the business very well, and you knew the industry, and you are highly confident about the future growth of the business. You could even just hold one stock, one stock in your portfolio, and that sounds hugely risky, right? But have a listen to this next clip of Warren Buffett explaining why that can be a safer bet than simply forcing yourself to diversify.

“A really wonderful business is very well protected against the vicissitudes of the economy over time and competition. I mean, you know, we’re talking about businesses that are resistant to effective competition, and three of those will be better than 100 average businesses, and they’ll be safer, incidentally. I mean, there is less risk in owning three easy-to-identify wonderful businesses than there is in owning 50 well-known big businesses. And it’s amazing what has been taught over the years in finance classes about that. But I can assure you that I’d rather pick—if I had to bet the next 30 years on the fortunes of my family that would be dependent upon the income from a given group of businesses, I would rather pick three businesses from those we own than own a diversified group of 50.”

Charlie, yeah! What he’s saying is that much of what is taught in modern corporate finance courses is twaddle. I love that summary by Charlie! But Buffett is absolutely right because we only look for high-quality businesses, you know—strong moats, low debt, well-managed, long-term compounders. We could hold one or two of these and be taking less risk in the long run than simply forcing ourselves to buy a hundred large-cap stocks in the name of diversification.

So overall, with this knowledge, how many stocks should you own in your portfolio? Well, hopefully this video shows that the answer to that question is simply however many companies you find that are high-quality businesses that you can also understand deeply. Maybe you find two, maybe you find five, maybe you can only find one. It’s not about the number of businesses; it’s about the quality of the business and your depth of understanding and also the price that you’re able to buy the business at.

Anyway, that will do us for today, guys. That is today’s video, that is my thoughts on diversification and how many stocks we should be holding in our portfolio. So let me know your thoughts in the comment section down below. Of course, you might have a differing viewpoint from me. Maybe you’re all about diversification. Again, I think that’s totally fine! If you’re someone that’s just trying to track the market, then go passive, diversify, and just don’t care about the market. But if you’re an active investor, I think that it’s less about, you know, how many stocks should I own; it’s more about how many stocks can I own? How many stocks can I keep up with in the depth that I need to keep up with them to make them a sound investment, to make sure that I’m going to make good money on each of those stocks?

So anyway, guys, that is it for today. Leave a like on the video if you did enjoy it. Comment down in the comment section below. Let me know what you think of diversification. What’s your personal take on it? Do you agree with these guys? Do you agree with Lynch, Munger, Buffett, Pabrai, or do you have your own take on it? Let me know. Subscribe to the channel if you haven’t done so already. And if you’re interested in how Warren Buffett goes about his investing strategy, and you want a full walkthrough of that investing strategy—it’s also the one that I follow, the four-pronged approach—then definitely check out Introduction to Stock Analysis; that course is linked down in the description below. It is eight hours long if you're interested, so check that out. And you’re also supporting the channel financially if you do so, so I really appreciate it!

But thanks, guys, very much for watching. That will do us for today, and I’ll see you all in the next video. Hey guys, thanks for watching the video, and thanks to Hypercharts for sponsoring this video! If you’re a stock market investor and you are not using Hypercharts, I would seriously recommend you check them out. Essentially, what Hypercharts does is it takes all those nitty-gritty numbers out of the company’s financial statements and puts it into really nice, easy-to-understand charts. And they do that quarter after quarter after quarter, year after year after year.

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