Some people become millionaires by investing in shares. I would be quite happy to become one of them. But if I wanted to aim for a million in the stock market, I would not buy dozens and dozens of different shares, hoping one might be the next Amazon or Starbucks.
Rather, I would limit my portfolio to a small number of different companies. I think between five and 10 would be ideal for my purposes. Here’s why.
The power of greatness
As in most areas of life, the stock market has a number of strong performers – but only a few exceptional ones.
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The difference, over the long term, can be very significant in terms of the returns I might earn as an investor.
Imagine that I invest £20,000 in a basket of 20 shares that have an average compound growth rate of 7% annually. After 20 years, I would have quadrupled the value of my portfolio to over £80,000.
That certainly sounds good – and I think it is. But what if I had only invested in my top five ideas among those 20 shares and had managed to achieve twice as good a compound annual growth rate of 14%?
As it is an annual rate, over time the increases are exponential. So after 20 years, my £20,000 investment would be worth over £323,000.
In both cases I invested the same money for the same amount of time. I even bought the same shares in the second example as in the first one. The only difference was that in the second example I did not put money in the weaker performing shares and instead concentrated it in higher performing ones.
Spotting great shares to buy
Hindsight is a great thing. But how could I know what shares will grow most in value at the start of the investment period, rather than just after it?
There is no way of knowing. However, I think I could make some educated assumptions.
Imagine that I made a list of my 20 strongest investment ideas at the moment, then tried to put them in order from best downwards. I doubt I would predict their future performance ranking accurately. But I reckon I could make some correct assessments about what shares had the strongest prospects even among a promising group of candidates. Some winners could be clearer than others even in advance.
While I might be broadly right, the unexpected can always happen. That is why I would be willing to invest the £20,000 into my top five ideas but not just my favourite one. Diversification is a critical risk management tool for me as an investor.
Following Warren Buffett
The above exercise is actually identical to one used by billionaire Warren Buffett to help his former pilot prioritise his career goals.
He takes a similar approach when it comes to choosing shares. Just five shares account for almost three quarters of the Sage of Omaha’s portfolio.
I may never achieve Buffett’s level of investing success. But if I wanted to aim for a million today in the stock market, I would invest a sizeable sum of money either now or over the course of time. Crucially, I would put it into a small number of shares I regard as outstandingly attractive investment opportunities.
