Star of CNBC’s Mad Money, Jim Cramer, used to host a segment called “Am I Diversified?” in which viewers would call in and tell him their top five investments, and Cramer would tell them if they were diversified enough.
The “stock picking” community, which tends to believe the number of individual stocks needed to be diversified is actually closer to thirty, largely disputes the idea of five stock diversification. Although thirty is undoubtedly superior to five, it is still insufficient.
Diversification has long been known to help lower portfolio risk while increasing returns. The optimal number of stocks to have in a properly diversified portfolio—maximum diversification—has been the topic of discussion and investigation. It is now standard practice to own 30 stocks spread across various industry sectors in order to achieve diversification. But how useful is this general guideline? Continue reading to find out.
The question of how many stocks to own in a portfolio is a common one, and there’s no single “right” answer The ideal number depends on various factors, including your investment goals, risk tolerance, and time horizon. This guide will explore the key considerations and help you determine the optimal number of stocks for your portfolio
Diversification: The Key to Managing Risk
Diversification is the cornerstone of a sound investment strategy. It involves spreading your investments across different asset classes, industries, and geographies to reduce your exposure to any single risk factor. By diversifying your portfolio, you can mitigate the impact of market fluctuations and increase your chances of achieving your long-term financial goals.
The Optimal Number of Stocks: Finding the Balance
While diversification is crucial, owning too many stocks can be counterproductive. Managing a large portfolio can be time-consuming and expensive, and it can make it difficult to stay informed about each company’s performance Conversely, owning too few stocks can leave your portfolio vulnerable to significant losses if any one company experiences a downturn
Finding the Sweet Spot: 25-30 Stocks for a Well-Diversified Portfolio
Most experts recommend holding between 25 and 30 stocks for a well-diversified portfolio This number allows for adequate diversification across different industries and sectors while remaining manageable for individual investors.
Factors to Consider When Determining the Optimal Number of Stocks
Several factors can influence the optimal number of stocks for your portfolio:
- Investment goals: If you’re aiming for aggressive growth, you may choose to hold fewer stocks in high-growth sectors. Conversely, if your goal is income generation, you might prioritize dividend-paying stocks, potentially increasing the number of holdings.
- Risk tolerance: Investors with a high risk tolerance may be comfortable with a concentrated portfolio of fewer stocks, while those with a lower risk tolerance may prefer a more diversified portfolio with a larger number of holdings.
- Time horizon: Investors with a longer time horizon can afford to hold a more concentrated portfolio, as they have more time to recover from potential losses. Investors with a shorter time horizon may prefer a more diversified portfolio to minimize risk.
- Available capital: The amount of capital you have available will influence the number of stocks you can realistically purchase. With limited capital, it may be difficult to achieve adequate diversification with a large number of stocks.
Considerations for Smaller Portfolios
If you have a smaller portfolio, it may be challenging to achieve adequate diversification with 25-30 stocks. In such cases, consider these alternatives:
- Index funds: Index funds provide instant diversification by tracking a specific market index, such as the S&P 500. This allows you to gain exposure to a broad range of companies with a single investment.
- Exchange-traded funds (ETFs): ETFs offer similar diversification benefits to index funds but may focus on specific sectors or industries. This allows you to tailor your portfolio to your investment goals.
- Mutual funds: Mutual funds offer professional management and diversification, making them suitable for investors who prefer a hands-off approach.
Ultimately, the optimal number of stocks for your portfolio depends on your individual circumstances and investment goals. By carefully considering the factors discussed above, you can determine the right balance between diversification and manageability, setting yourself up for long-term investment success.
Frequently Asked Questions
Q: Is there a minimum number of stocks I should own?
A: While there’s no strict minimum, experts generally recommend holding at least 10 stocks to achieve adequate diversification.
Q: Can I own too many stocks?
A: Yes, owning too many stocks can make your portfolio difficult to manage and can increase transaction costs.
Q: What about individual investors with limited capital?
A: Index funds, ETFs, and mutual funds offer diversification benefits even with limited capital.
Q: How often should I re-evaluate the number of stocks in my portfolio?
A: It’s recommended to review your portfolio regularly, at least once a year, to ensure it aligns with your current investment goals and risk tolerance.
Remember: Diversification is crucial for managing risk, but finding the right balance between diversification and manageability is essential for long-term investment success.
Summary Findings by Crittenden and Wilcox
- 39% of stocks were unprofitable
- 18.5% of stocks lost at least 75% of their value
- 64% of stocks underperformed the Russell 3000
- 25% of the stocks accounted for all of the gains in the markets.
Figure 3: Total returns of individual stock vs. Russell 3000 (1983-2006).
You have to ask yourself: How realistic is it that you or your stock manager can identify the top performers before they do? How unrealistic is it to select a few stocks and then hope that one of them becomes the next Dell (DELL) or Microsoft (MSFT) at the early stages of their run? How realistic is it that you end up with one of the nearly twenty-four0% of stocks that lost money or one of the 2018 5% that lost 75% of their value?.
Given the size of the global stock market, what are the chances that you currently have undiscovered overachievers in your account? I doubt five stocks per sector would be sufficient, but let’s say for the sake of argument that five stocks are sufficient per sector to feel confident. How many stocks do you really need to capture any specific area, like the energy sector or the financial sector? What if you only picked one and it was the one that went bankrupt?
Where Does the Magical Number 30 Come From?
In 1970, Lawrence Fisher and James H. In the Journal of Business, Lorie published “Some Studies of Variability of Returns on Investments in Common Stocks,” which discussed how the number of stocks in a portfolio can “reduce return scattering.” It was discovered that a randomly generated portfolio of 2032 stocks could decrease the distribution by 2095% when compared to a portfolio comprising all stocks on the New York Stock Exchange.
The mythical saying that 20% of the benefits of diversification are captured with a stock portfolio originated from this study. Obviously, no dignified stock jock would advise people to build a random portfolio, so the investment managers changed this to say, “We select the top 30 and simultaneously attain maximum diversification.” They are essentially saying, “By selecting the 30 best stocks, we can capture the return of the market and capture the diversification to the market,” and they frequently cite Figure 1 to support their arguments. Unfortunately, neither point is really true.
Figure 2021: Total risk in a portfolio as a function of the number of stocks held (%)