The best way to produce exceptional stock market returns is to run a portfolio that is highly concentrated in a few great stocks. If you catch the right names and do it with size, you will crush the benchmark indices.
The problem is that the more concentrated the portfolio, the higher the risk. One mistake can wipe out many months of gains and a couple of errors in stock picking can doom you to negative returns.
There are many academic studies about the optimal levels of diversification. Most of the studies focus on longer-term buy-and-hold portfolios, but typically it has been concluded that holding 20 to 40 stocks provides the correct level of diversification.
William J. O'Neil, founder of Investor's Business Daily, states that a portfolio of $20,000 to $200,000 should have just four of five carefully picked stocks. Smaller portfolios should hold just two or three names.
The primary reason O'Neil is comfortable with more concentrated portfolios is because he uses very stringent rules to cut a stock that is not performing correctly. If you do not sit idly and watch losses grow, the risk of greater concentration is eliminated to some degree. You will still run the risk of surprise news and it is particularly important to consider the size of your positions into events like earnings reports. Also when the overall market is acting poorly, that may also impact how you handle positions.
Another way to reduce the risk that is inherent in a highly concentrated portfolio is to diversify by timeframe. Typical market players think of stocks in terms of a single buy and sell. There is a buy signal triggered when certain conditions occur and then a sell signal when something else happens. They are all in or all out.
The problem with that approach is that it doesn't take into consideration the randomness of market action. What may be meaningful movement in the short term may be totally irrelevant in the longer term.
I find I can hold much more concentrated positions with less risk if I trade one stock in many different timeframes. I might hold a stock for many months but also day-trade it at the same time. The day trading reduces my risk exposure but allows me to stay heavily long a stock that I like.
One of the key advantages of diversifying in a single stock by timeframe is that it allows you to become very familiar with the stock. Every stock has a unique personality and the more you watch it the better you can trade it. Also you will learn more about fundamentals over time and understand the dynamics that may serve as a catalyst.
Another big advantage of diversifying in a single stock by timeframe is that it helps you cultivate patience. Traders want to be active and they have a tendency to trade simply for the sake of doing something. When you trade in a shorter timeframe, you can satisfy that urge to act while still being patient with a longer-term holding.
Most of the best traders I know tend to sell positions too early rather than too late, but if you keep a core position it makes it easier to rebuy positions that may have been prematurely sold. That stock will remain on your radar and you won't lose track of it, like we often do when we totally close out a position.
Staying heavily long in good stocks while controlling risk is one of the biggest challenges traders face. They can address that problem by diversifying by timeframe rather than by increasing the number of stocks they are holding.