Over the last few weeks, we’ve been sharing some of the Five Secrets of Small-Cap Investing as practiced by history’s best investors. The Fourth Secret of Small-Cap Investing: Invest Less in More Stocks.
Stock investors should always aim to hold a diversified portfolio of stocks, spread out among companies of all sizes and in many different industry groups and sectors. At the same time, it’s important to concentrate a stock portfolio into a small number of holdings. Research shows that a portfolio of more than 20 stocks adds little diversification benefit and actually reduces the chance that the portfolio will outperform the broad market averages. Most investors can see the maximum levels of risk and return with a portfolio of between 12 and 20 individual stocks.
Since small-cap stocks have a higher risk profile than larger stocks, though, some modification to this portfolio strategy may be in order. Risk can be diluted in a portfolio by spreading small stock exposure among a greater number of individual companies.
For example, an individual investor who seeks to own 12-15 stocks in a portfolio, with 25% of the overall value of the portfolio directed to small-company opportunities, would aim for four to seven small companies instead of three to five companies. By adding more small companies, the risk of a single company underperforming is thus somewhat mitigated.
Next: the fifth secret to small-cap investing: Replenish Small-Cap Exposure Regularly.
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