Great trading is a balancing act. You want to take on enough risk so that you can produce big gains but not so much that it causes substantial loss should you make a mistake or be hit with bad luck.
In theory, your best chance of producing a huge gain is putting all your money in your best pick and hoping that you are right. That might be a good idea if you are a gambler or you can afford to lose a substantial amount of capital, but if you are trying to build long-term wealth, this just isn't the way to do it. Even if the stock you favor turns out to be a winner, the volatility is almost always just too great at times if you are too heavily invested in just a couple of stocks. Even long-term winners like Apple (AAPL) pull back 50% or more at various times.
One way to control risk is to use a very short time frame. Many of the new social media traders use a style of trading just one or two stocks in very short time frames and then moving on to the next opportunity. Essentially what they are doing is diversifying by time frame. The short time frame serves the same purpose as holding a diverse number of stocks longer term. Risk is controlled in a different way, but it also limits returns to some extent.
The amount of capital that you are working with will also have a major impact on the number of stocks you are holding. It isn't possible to be highly diversified if you are holding just a small amount of capital. On the other hand, there are large funds that will hold many hundreds of stocks because there isn't any other way to put their capital to work.
If the amount of capital you are working with is small, you face the challenge of being too concentrated. However, if the amount of capital is too large, you are faced with not being concentrated enough. The best returns are often earned by investors with mid-six-figure accounts that can straddle the fence between the two extremes.
William J. O'Neill is the founder of Investor's Business Daily. His CAN SLIM method is a position-trading approach to growth stocks. He has suggested that accounts of less than $20,000 should hold no more than three stocks, following parameters. Those between $20,000 and $200,000 should hold four or five, and those up to $1 million should hold six or seven.
That information may be a bit dated, but it shows how concentrated some investors feel they need to be in order to produce superior returns. O'Neill believed that his stock-picking methodology and trade management would prevent major losses. He was not a buy-and-hold investor, and he had very strict rules on cutting losses. The thinking here is that when you are right, you have to go big in order to really profit.
Other famous traders and investors such as Jesse Livermore and George Soros also have preached the value of concentration. They have made fortunes when their big trades have worked, but they also have suffered spectacular losses when they have been on the wrong side of trades. In all cases, they have a high tolerance for volatility.
The factors that will determine the number of stocks you hold will be the amount of capital you are working with, your tolerance for volatility, your time frames, and your investing or trading style.
I find that I constantly have to push myself to take bigger positions. This is my biggest challenge because it causes uncomfortable levels of volatility at times. It is great when you are right, but the pain is tremendous when you are wrong.
In order to take more concentrated positions, I find that I need to have more rigid money management rules and trade in a more disciplined way. As I've often discussed, I use an incremental approach to trading, and this allows me to constantly change position size as my measures of risk start to shift.
The most important issue here is that we must stay cognizant of the fact that risk is always lurking, but we can control it in various ways with position size, time frames, and money management.
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"Trading" - Google News
October 30, 2021 at 09:00PM
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How to Diversify and Manage Risk in Trading - RealMoney
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