How Many Stocks Do You Need to Be Diversified?

by Daniel J. Burnside

Among those who invest in individual stocks, one of the most commonly misunderstood concepts is that assured diversification can be accomplished with a relatively small portfolio of common stocks. Many people believe that diversification beyond 10 or 20 securities is superfluous despite clear research indicating that the opposite is in fact the case. Even some investment textbooks have helped spread the confusion.

The major reason for the confusion rests with the interpretation of many of the studies that have examined the relationship between the risk of a portfolio and the number of securities that it holds.

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Daniel J. Burnside , Ph.D., CFA, is vice president of Clover Capital Management in Rochester, New York, and lecturer in finance at the University of Rochester's William E. Simon Graduate School of Business Administration.
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In this article, we clarify the previous findings by taking a fresh look at this relationship.

In addition to the misunderstanding of portfolio size and risk reduction, investors need to be aware of an increased need for diversification.

Diversification: Getting Rewarded for Risk

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→ Daniel J. Burnside , Ph.D., CFA, is vice president of Clover Capital Management in Rochester, New York, and lecturer in finance at the University of Rochester's William E. Simon Graduate School of Business Administration.

Discussion

It certainly makes sense that the more stocks you own, then the closer you will be to the diversification of the market. However, as an active investor, my goal is not to be as diverse as the market. I want to outperform the market by selecting a limited number fundamentally sound stocks and by using technical analysis to place the odds in my favor when timing my buys and sells. Personally, I rely, in part, on the market assessment published by IBD to decide when to be fully invested and when to be raising cash.

posted about 1 year ago by Craig from Illinois

I would prefer to have 100 stocks that outperform an index to having 10 stocks that outperform an index. But, to reach 100 I would have to compromise on quality. Moreover, for an average size portfolio, the additional trading costs for 100 stocks would probably exceed the benefit of diversification. Now, that would be a worthy subject for research!

posted about 1 year ago by Louis from Michigan

This analysis takes an all or none approach meaning that you are exclusively in individual equities or you are in mutual funds. My approach has been to have a taxable portfolio of individual dividend stocks(currently 12)with a yield in the 3.5% to 3.8% average range. For diversification I own mutual funds that are divided between large, mid, and small cap, growth and value, international and a REIT index and are more than double the size of my dividend portfolio and are held in tax deferred investments. For tax purposes I am taking advantage of the tax breaks for qualified dividends as well as capital gains with my dividend portfolio.

posted about 1 year ago by John from Connecticut

I cannot understand the concept of picking stocks randomly without understanding what we are doing. I follow a similar strategy as John where I pick stocks that I understand and combine it with ETF's in asset classes I do not understand like emerging markets, REITs, commodities and bonds.

posted about 1 year ago by Prabhu from Connecticut

Mr. Burnside's analysis is impressive. I am not quibbling with his conclusions. But, here is the irony. If you're going to own 50-250 stocks in order to achieve a high level of diversification, why go to the trouble? You might at as well invest in a mutual fund or ETF that tracks the S&P 500 Index.

posted about 1 year ago by James from Ohio

How many shares should one have in a stock?