Have you ever wondered, "How much diversification is enough?" It's a question that plagues new investors often, especially once they realize the powerful, mathematical advantages of diversification. It provides not only protection against the downside in case an individual business runs into trouble, but also a bit of a lottery ticket on the upside—one of your holdings could turn into a superstar performer like Amazon or Apple.
Luckily, academics have looked at this issue for generations, and they have arrived at a fairly narrow range of total stocks that need to be held in an investment portfolio to maximize the benefits of diversification.
Let's take a look back at the history of the stock market diversification debate by looking at the four major studies you are likely to encounter in your research into diversification.
- Over the years, several studies have tried to pinpoint the number of stocks you should hold to lower the risk of failure.
- You can own as many stocks as you like, but if you don't choose them wisely, you'll need hundreds to reduce the chance of failure.
- An index fund gives you instant diversity with hundreds of well-researched stocks.
10 Stocks May Be Enough
One of the first times a serious academic work in the modern world attempted to answer the question "How much diversification is enough?" came in December of 1968 when John L. Evans and Stephen H. Archer published a study called Diversification and the Reduction of Dispersion: An Empirical Analysis.
Based on their work, Evans and Archer discovered that a fully paid, debt-free portfolio (in other words, no margin borrowing) with as few as 10 randomly chosen stocks from a list of 470 companies that had complete financial data available for the prior decade (1958 through 1967) was capable of maintaining only one standard deviation, making it practically identical to the stock market as a whole.
This approach of selecting random firms without any regard for the underlying security analysis, including income statement and balance sheet study, is known as "naive diversification" in the academic literature.
An investor who engages in naive diversification exercises virtually zero human judgment. The strategy makes no distinction between companies drowning in debt and those that don't owe anybody a penny.
The core of their findings was that, as diversification is increased through adding additional positions to a stock portfolio, volatility (which they defined as risk) decreases. However, there comes a point at which adding a name to the investment roster provides very little utility but increases expenses, lowering return. The objective was to find this efficiency threshold.
Maybe You Need 30 or 40 Stocks
Nearly 20 years later, Meir Statman published How Many Stocks Make a Diversified Portfolio? Statman insisted that Evans and Archer were wrong. Instead, for a debt-free investor, the minimum number of stock positions to ensure adequate diversification was 30. For those who were using borrowed funds, 40 was enough.
50 Stocks Might Be Required
In February 2001, John Y. Campbell, Martin Lettau, Burton G. Malkiel, and Yexiao Xu published a study called Have Individual Stocks Become More Volatile? An Empirical Exploration of Idiosyncratic Risk. It concluded that volatility had become sufficiently higher since older studies were conducted, such that achieving the same relative diversification benefits required a portfolio of no fewer than 50 individual stocks.
Maybe 100 Stocks Aren't Enough
In November 2007, a study called Diversification in Portfolios of Individual Stocks: 100 Stocks Are Not Enough got a lot of attention for its real-world assessment of diversification and risk. The study authors concluded that, to reduce the chances of failure to less than 1%, a randomly assembled portfolio had to include 164 firms. Portfolios with less diversification yielded worse results:
- If you went with a 10-stock portfolio, you had a 60% probability of success, meaning a 40% chance of failure.
- If you went with a 20-stock portfolio, you had a 71% probability of success, meaning a 29% chance of failure.
- If you went with a 30-stock portfolio, you had a 78% probability of success, meaning a 22% chance of failure.
- If you went with a 50-stock portfolio, you had an 87% probability of success, meaning a 13% chance of failure.
If you went with the 100-stock portfolio mentioned in the study title, you had a 96% probability of success, meaning a 4% chance of failure. That may not sound like a lot, but the stakes are higher when talking about your standard of living, especially when there's an alternative strategy that reduced that risk to 1%.
Benjamin Graham's Advice
Benjamin Graham, the man who created the strategy of value investing in the 1920s, also studied diversification. He suggested that investors own at least 40 stocks at a time in order to reduce risk.
However, that was just one aspect of Graham's advice for investors. He also insisted on defensive tests to ensure that you're buying good stocks at a cheap price. Some defensive tests he suggested included:
- Adequate size of enterprise
- Sufficiently strong financial condition
- Earnings stability
- Established dividend record
- Established earnings growth
- Moderate price-to-earnings ratio
- Moderate ratio of price-to-assets
Graham favored established, rational metrics. Take, for example, the performance of airline stocks versus consumer staples stocks. The probability of an airline company declaring bankruptcy, due to fixed costs and variable revenues with a total lack of pricing power, is radically higher. In contrast, the consumer staples enjoy much more variable cost structures, huge returns on capital, and real pricing power. Even if both are trading at a similar earnings multiple on a given trading day, an investor with Graham's teachings in mind will choose the more stable consumer staple stock every time.
The Bottom Line
Obviously, you can always own 100 stocks or more, if you like. These studies offer a lot of helpful advice and evidence to study, but every investor will have to find a balance that works best for them. In a world of low-cost (or free) commissions, it's easy to trade in and out of positions as often as you like. Alternatively, you can ignore all of this theory and buy an index fund that instantly replicates the diversification of owning dozens or hundreds of different stocks.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.