Today I am going to reveal to you something I know you may have asked yourself.
Suppose you want to start building your portfolio of stocks tomorrow.
How many different stocks do you buy?
Ten? Twenty? Fifty? One hundred?
If you said “ten” stocks, how do you know that 10 is the right number? What if 10 is too risky?
If you said “a hundred” – why that number? Why not 200 or 150?
So let me reveal to you a secret and easy formula to decide exactly how many different stocks to buy, when you are building your portfolio.
I say it is a “secret” formula because not everyone knows about it – even though it is very easy to understand.
The formula comes from Andrew Wellington, who runs a billion dollar hedge fund (and is ranked as one of the best 100 hedge funds by Barrons).
Wellington starts by looking at a selection of 1000 different stocks, and then chooses just 33 stocks for his portfolio.
Yes, your eyes saw that correctly.
He selects 33 stocks from a basket of 1000.
Wellington chooses the most undervalued stocks of companies that are also great businesses.
Now you may be wondering why 33 stocks exactly? Why not 50 or 100?
There is nothing magical about the number 33.
Wellington arrives at this number like so:
Let’s say you want to take a 3% position in a stock called ABC. If you have $10,000 to invest (your capital), you would invest no more than $300 into that stock – because 3% of $10,000 is $300.
Now let’s say we want to take a 3% position in every undervalued stock we want to buy. This means we would invest no more than $300 into the stock of each company (again, based on a $10K capital).
If you think about it, if you take a 3% position in each different stock, the MAXIMUM number of companies you can invest in is 33. Here’s why:
33 company stocks x 3% = 99% of your total capital to invest.
According to Wellington 3% gives you the best balance between risk and reward. 3% is big enough to make an impact on your portfolio, but also small enough to protect you from too much risk.
For example, imagine you had chosen to take a 10% position in each stock. This would limit you to only 10 stocks. If the share price of one of those 10 stocks dropped massively due to some bad news, the loss you would incur would be significant and your portfolio would take a major hit.
This is because you had invested 10% or $1,000 of your $10K capital into that stock.
By the way, I have heard crazy stories of people who have put their entire life savings into just one or two stocks (one of my good friends has his entire pension stuck in a very well known tech stock).
Back in 2008 when the great recession started, many people saw the error of having their whole pension stuck in the company they worked for. When those companies went bankrupt, their savings were wiped out.
You may be asking why not choose 100 stocks, and therefore place only 1% in each stock. This would limit your risk on each stock to only 1%.
This is OK in my opinion, but according to Wellington, a 1% position would spread you too thin.
Again, the idea is that your position must be big enough to make a difference but not exposing you to too much risk.
By the way, I should emphasise that Wellington’s formula is for long term investing – in other words, he intends to hold these stocks for a very long time.
This formula was NOT meant to be used for short term trading or swing trading.
For short term or swing trading, I consider 3% risk on a single trade to be too large (unless your trading account is very small, such as <$1000). This is because trading in general exposes you to a lot of volatility, randomness and “noise” in the markets – so care must be taken to REDUCE risk as much as possible.
In trading, generally 1% risk (or even less) per trade is in my view the safest recommended amount of risk to take.
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