10 Stocks - That's All You Need

There are over 6000 stocks traded publicly on the various United States stock exchanges. Many are substandard no-names you may have never heard of. Then there are the larger well-known names in the S&P 500 or Dow Jones indexes. All you need to get rich over time is 10 of them. Any more than that will ensure you remain average.

In the math behind statistics (everyone's favorite high school or college course! NOT!), if you take a random sample of 30 items in a set of say 1 million, the small sample is highly likely to properly assess the characteristics of the entire 1 million.

Obviously, with the small sample, there is an error factor, of +/- x%. Choose less than 30, and your error factor increases significantly. Choose more than 30, your error factor may go down, but the cost of surveying a larger sample goes higher, usually to the point of diminishing returns on accuracy. There is a mathematical reason the Dow Jones Industrial Average contains just 30 stocks that we all use to assess the entire stock market!

The S&P 500 index, with 500 midsize to large companies, provides a more accurate representation of the entire market. And until mutual funds became popular in the 1980s, most people could not afford to own all 500.

The problem with owning at least 30 stocks, and more so with 500 stocks, is that you are assured of never beating the market averages. Statistically, ownership of this number of stocks will increase or decrease in value at nearly the same rate as all 6000 stocks combined. The best you will do over time is exactly what the entire market is doing, which averages roughly an 11% average annual return over a 20, 30, or 40 year period.

A consistent 11% return is a good return, and will make you moderately wealthy over time. But if my goal is to achieve a 20% or more annual return, how do I do better while remaining diversified enough and relatively safe?

To consistently beat the market averages, I must own less than 30 stocks. And ideally, that number will be between 5 and 10. Owning this number of stocks assures I remain adequately diversified, but not so diversified that I cannot beat the market averages.

The next question is how do I choose the 10 stocks?

I first start with the S&P 500. Out of that list, I can easily eliminate half that are either overpriced, or in sectors that may be politically out of favor. This quickly narrows the list to 250. Still too many.

Now I look at the 250, and cut the list in half again to 125. Perhaps I choose industries I understand better than others. I personally know technology, finance, retail, energy, telecommunications, manufacturing, insurance, and real estate very well. Having never worked in the fields of medicine, biotechnology, travel, or similar, I probably want to stay away from stocks because I simply lack the intuitive understanding of their businesses, even if the numbers look good. It is better to stick with businesses and industries I understand and frequently follow.

125 stocks is still too many. I need to cut the list in half again to about 60. As my readers know, I am a huge fan of dividend-paying stocks. They tend to be more stable, especially during the mostly unpredictable downturns. That said, there may be some promising stocks that don't pay dividends, so I don't want to exclude all of them. Maybe I allocate 70% of the stocks I pick to those paying dividends, and only up to 30% for those not paying dividends.

At this point, I am down to 60 stocks, and if I cut the list by half just 3 more times, narrowing my list to the best of the best for those things I know well, I can get a list of 7 to 10 stocks that will outperform the S&P 500 consistently well.

At this point, I have 10 high quality stocks, and I can either invest equally in all of them, much as the stock averages do, or invest more heavily in some than in others. Starting out, since valuation was already part of the criteria, it is better to invest in each equally.

If you are like most people, every paycheck you have a few extra dollars allocated towards investments. Where do I put these funds? Which stock do I buy?

With every paycheck or dividend, I will allocate new funds to the stock with the best valuation relative to its past and expected earnings. In other words, I am buying more of the cheapest one of the 10.

Finally, every year, I will perform this entire exercise again, perhaps coming up with a slightly different list. I will then cull the weakest stocks of my list, and replace with the new stocks from the new list. With this exercise, you will quickly learn that often the best to buy is one you already own.

If I do an effective job in the evaluation, a list of 10 well-chosen stocks will outperform the S&P 500 on a near consistent basis. Will I hit consistent 20% returns? Maybe. And sometimes a lot more, and sometimes less. But either way, I can nearly guarantee I will do better than the average 11%.

The one risk with this approach is if I stumble across the "Enron" situation, where the company's numbers lie, the executives are corrupt, and the company goes completely out of business.

Hopefully, I am following the news on my companies in such a situation, and can sell before the stock goes completely to zero. Rule of thumb: When financial accounting is seriously questioned and severe fraud is alleged, sell first and ask questions later. Your risk substantially changed, and where there is smoke, there is usually fire.

But let's assume the stock goes to zero, and I held on the entire time thinking the situation would improve. At most, I would lose 10% of my portfolio that year, but if the remaining 90% of the portfolio is up 20%, I still make an 8% for the year. These situations, while making news headlines for years, are rare. But they can, and sometimes do, happen.

To become wealthy, all you need over time is just 10 stocks!

I am fortunate enough to have a 401k retirement account which offers the ability to invest in individual stocks through a "self-directed brokerage fund", instead of just the standard selection of widely diversified mutual funds. I can therefore use this approach with my retirement funds, instead of just with non-retirement funds.

If you are only offered mutual funds in your retirement plan, you can usually still skew the weighting towards different sectors that would do better, while keeping a majority in an S&P 500 fund. But retirement funds should not be your only investments. It is best to also build long-term assets outside of your retirement accounts, and with non-retirement funds, you can invest however you please. If you have money in an old 401k from a previous employer, those funds can be rolled to an IRA at a brokerage like Schwab or Fidelity, and you will be allowed to use this strategy.

The real question is, do you want to do just average? Or do better than average? To do better than average, 10 stocks will do the trick!