Since investing in just one stock can be very risky, most investors invest in two or more stocks. This collection of stocks is called a ‘Portfolio’.
Choosing the right stocks to invest and correctly constructing a portfolio, is what sets apart successful investors from those who fail in the stock market.
Mutual Funds tend to spread out their risk by investing in many companies – this is called a diversified portfolio, which usually has 20 or more companies.
Experienced investors who are aggressive and want to beat the market, usually opt for fewer stocks. They give high allocation to companies where they have high conviction (i.e confidence that the company will perform well). This is called concentrated portfolio, which usually has 10 stocks or less.
Concentrated portfolio can be risky – not just for new investors, but for anyone who invests in the stock market. This is because concentrated portfolios can sometimes have 25% or higher allocation towards one stock. If that company under-performers or there is some bad news related to the management (rumours of fraud etc) – the investor can lose a huge chunk of his investment.
On the positive side, if a high-allocation investment does well – the investor can create extraordinary wealth in a short period of time.
Concentrated portfolio is only for those who are aware of the risks and are capable of doing in-depth research into a company.
New investors should avoid investing more than 5% of their total investment into one stock. A portfolio of 20 stocks or more (i.e diversified portfolio) can spread out the risk. Investors can also give stability to a portfolio by giving 50-75% allocation to well-known blue chip companies. The rest 25% can be invested in quality mid cap or small cap companies.