Number of Stocks in Portfolio: Warning Signs and Strategies from Warren Buffett
Warren Buffett, the Oracle of Omaha, flips the script on traditional portfolio diversity. While financial advisors usually suggest you hold between 20 to 30 stocks, Buffett's approach is as unique as he is, making him a billionaire investor.
1. The Philosophy: Diversification is a Blindfold Against Knowledge
Buffett said, "Diversification is protection against ignorance." This philosophy divides him from mainstream financial advisors. According to Buffett, diversification is a security net for investors who lack knowledge and ability to dissect businesses effectively.
However, excessive diversification is detrimental to those who truly understand business analysis and can identify exceptional enterprises. This philosophy challenges the notion that spreading investments across numerous holdings automatically decreases risk and improves returns.
2. The Paradox: The Disconnect Between Business Ownership and Stock Ownership
The discrepancy between theory and practice unveils itself when comparing business ownership to stock investing. If someone owned three to five different businesses, you'd consider them well-diversified in your local town. Yet, experts recommend holding upwards of 20 to 30 stocks in the stock market.
Buffett argues that this conventional advice reflects an understanding gap regarding what it means to own stocks, as it contradicts our perception of business ownership.
3. Buffett's Early Portfolio Strategy: The 1960s Blueprint
In Buffett's 1962 partnership letter, he outlined his early diversification strategy known as "The Generals." During this era, he usually allocated 5% to 10% of total assets to each of five or six core positions, with smaller positions in another ten to fifteen stocks. This construction meant that around 50% of his portfolio was concentrated on his top picks, while another 30% was distributed among additional holdings, totaling around 20 stocks representing 80% of his capital[2].
His selection criteria were straightforward: companies available at very low prices relative to their business value, diversified across different industries to provide less correlated portfolio risk. Buffett noted, "Combining this individual margin of safety, coupled with a diversity of commitments, creates a most attractive package of safety and appreciation potential."
4. Quality Over Quantity: Why Six Stocks May Be Adequate
Buffett's perspective on portfolio size highlights quality over quantity. "Very few people have gotten rich on their seventh-best idea," he observes. He suggests that for normal investors working with fewer funds, six stocks can provide adequate diversification[2], provided they operate in different industries and the investor has thoroughly analyzed their fundamentals, price action, and historical trends.
This concentrated approach necessitates investors to focus on their highest-conviction ideas rather than spreading money thinly across numerous mediocre opportunities. The key lies in deep knowledge and understanding of each investment instead of achieving diversification through sheer numbers.
5. The Sweet Spot: Active Investors Should Limit To 20-25 Stocks
Research indicates that as the number of stocks in a portfolio reaches 20 to 25, the volatility-reducing benefits of diversification approach zero[3]. This range offers the ideal balance for investment-seeking those who aim to outperform the market while deriving meaningful diversification benefits.
After this number, additional holdings provide minimal risk reduction, potentially diluting the impact of an investor's best ideas. Buffett acknowledges that few people need this many positions, classifying the range between 20 to 25 stocks as the maximum number where diversification still provides tangible benefits to stock investors.
6. Insanity Beyond 40 Stocks
Buffett's longtime partner, Charlie Munger, doesn’t hold back when discussing excessive diversification: "It's absolute insanity to think that owning 100 stocks instead of five makes you a better investor." Buffett agrees, stating that 40 stocks are too numerous for small investors[4].
Rather than attempting to manage such an unwieldy number of positions, he recommends that investors invest in a S&P 500 index fund for broad market exposure. This index provides diversification across over 500 stocks spanning different sectors, eliminating complexities and time commitment required to research and monitor dozens of individual companies while still achieving diversification.
7. The 90/10 Rule: Buffett's Advice for Average Investors
For investors who prefer a passive approach or lack the time and expertise to analyze individual companies, Buffett champions the 90/10 rule. This approach allocates 90% of investment capital to stock-based index funds while placing the remaining 10% in lower-risk investments such as government bonds.
His preferred vehicle is the S&P 500 index fund, options such as the SPDR SPY ETF or Vanguard's VOO. This strategy is based on his observation that the S&P 500 consistently outperforms most actively managed mutual funds and hedge funds while offering significantly lower management fees. Buffett publicly stated that his wife's inheritance will follow this allocation, demonstrating his confidence in this method for investors who don't wish to research individual stocks actively.
8. Three Top-Notch Companies vs. 50 Average Ones
Buffett's conviction in concentration over diversification is cemented by his statement: "I could pick out three of our businesses, and I'd be thrilled if they were the only businesses we owned." He believes that owning three fantastic businesses is more than enough to secure an extensive future.
Historical analysis supports this belief, as most American fortunes weren't created through portfolios consisting of 50 companies but rather through targeted investments in exceptional businesses. Coca-Cola is an example, creating numerous fortunes for those who recognized its potential early and took substantial positions[1].
9. Modern Portfolio Theory is "Twaddle" According to Munger
Charlie Munger saves his harshest criticism for Modern Portfolio Theory, dismissing much of what's taught in finance courses as "twaddle." Despite its mathematical complexity and sophistication, he argues that Modern Portfolio Theory provides no actual utility beyond teaching investors "how to do average."
Munger points out that the theory's elaborate formulas, Greek letters, and complex models create a facade of sophistication without offering concrete value. His critique extends to the broader academic approach to investing, suggesting that if investors truly understood Buffett's principles, entire finance courses could be reduced to a single week, stripping the mystique that often surrounds investment theory.
10. Concentration vs. Diversification: How Buffett Built His Fortune
Buffett's personal investment approach mirrors his philosophy. He frequently discusses owning essentially one stock personally, Berkshire Hathaway, representing nearly his entire wealth. This extreme concentration strategy played a significant role in turning him into a billionaire by age 50 and preserving his position among the world's wealthiest individuals for decades.
His personal stock portfolio, which he often discusses with his Coca-Cola and Apple stocks, represents almost entirely his Berkshire stock portfolio that he manages. He adheres to his advice with this portfolio, concentrating his best ideas on the top holdings.
11. Practical Guidelines: How Many Stocks Should You Own?
The practical application of Buffett's philosophy depends on an investor's knowledge level and involvement. For knowledgeable investors who genuinely understand business analysis, three to six carefully chosen stocks may offer optimal returns.
Active investors aiming to outperform the market should consider a maximum of 20 to 25 positions to capture diversification benefits without diluting their best ideas.
However, for investors who prefer a passive approach or lack the time and expertise to analyze individual companies, Buffett suggests adopting the 90/10 rule, prioritizing inexpensive S&P 500 index funds. Ultimately, the critical factor isn't the specific number of holdings but rather an investor's genuine comprehension of their investments.
- Portfolio diversification for knowledgeable investors like Warren Buffet is seen as a form of ignorance, as they believe that owning a small number of carefully chosen stocks allows them to identify exceptional businesses and achieve higher returns compared to excessive diversification recommended by many financial advisors.
- Buffett believes that investing in a few quality stocks is more advantageous than relying on excessive diversification to achieve risk reduction and improved performance. In his view, owning a handful of carefully analyzed stocks that operate in different industries can provide better returns than spreading investments across numerous holdings.
