How Many Eggs? How Many Baskets?

10/14/2011 10:00 am EST


John Heinzl

Reporter and Columnist,

Investing in a mixed bag of low-cost index funds, at least for the core of your portfolio, can reduce your risk of landing in the poor house, writes John Heinzl, reporter and columnist for Globe Investor.

How many stocks do you need for a properly diversified portfolio?

This is a subject of much debate among academics and investors. Before we delve into the controversy, let’s review why diversification is important.

You’ve heard the expression "don’t put all your eggs in one basket." The investing equivalent is: "don’t put all your cash in one stock, or even one industry." By investing in a mixed bag of stocks and sectors, you spread your bets around, reducing the impact that any one stock or sector will have on your portfolio.

What’s more, if you choose stocks that have a low or inverse correlation with one another—that is, they don’t move up or down together—you further reduce the volatility in your portfolio. For example, banks and resource stocks plunged in response to worries about China and the debt crisis in Europe, but utilities, pipelines, and telecoms, which are less economically sensitive, were largely unscathed.

Pick a Number
In his influential 1949 book The Intelligent Investor, legendary value investor Benjamin Graham argued that a portfolio of just ten to 30 stocks provides adequate diversification. Increasing the number beyond that may reduce volatility marginally, but at the expense of higher transaction costs and more time required to monitor the portfolio.

In a similar vein, a classic 1968 paper entitled "Diversification and the Reduction of Dispersion," by professors John Evans and Stephen Archer at the University of Washington, argued that a portfolio of 15 randomly chosen stocks would have similar risk, as measured by standard deviation, to the market as a whole.

More recent studies, however, have concluded that the ideal number of stocks could be 50, 100, or even more.

"The academics disagree over how many separate stocks are required to secure the benefits of diversification, but most professionally managed equity portfolios have at least 30 or so individual securities in them," US fund manager Daniel Peris wrote in his 2011 book, The Strategic Dividend Investor.

Chasing the ’Superstocks’
Some investors pooh-pooh the notion that a few dozen stocks provides adequate diversification.

"To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you," investment advisor and author William Bernstein said in a paper called "The 15-Stock Diversification Myth."

While a 15- or 30-stock portfolio would significantly reduce volatility, it would also have a high probability of missing out on the small number of "superstocks" that drive most of the market’s gains, he said. He cited a study by researcher Ron Surz, who constructed 1,000 portfolios of 15 randomly chosen stocks, and tracked their returns over 30 years.

The top-performing random portfolios beat the market handily, but the worst portfolios missed out on most of the big gainers and trailed the market badly.

"Yes, picking a small number of stocks increases your chances of getting rich, but…it also increases your chances of getting poor," Bernstein wrote in his 2010 book, The Investor’s Manifesto.

What to Do?
To reduce the risk of ending up in the poorhouse, Bernstein recommends investing in broadly diversified, low-cost index funds that provide exposure to hundreds, if not thousands, of stocks.

What about investors who want to manage their own portfolios? While there is no magic number, it’s safe to say that the more stocks you own, and the more sectors you cover, the more diversified you’ll be.

Of course, you could always take a hybrid approach—invest in diversified funds for the core of your portfolio, and allocate a portion of your funds to individual stocks.

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