How Many Stocks Do You Need To Be Diversified?
Diversification is what's required of investors who aim to eliminate the risks unique to any one particular stock. I'm talking about risks such as a labor strike, poor corporate governance, or new competition. These risks are referred to as unsystematic risk. But this is only part of an investor's total risk. The other form of risk is derived from events like government regulation, interest rate changes, or fluctuating oil prices to name a few. We call this systematic risk, and no investor is immune.
The diversification theory goes that if an investor owns enough stocks, they've eliminated a big enough chunk of unsystematic risk, thereby reducing total risk and the potential for losing everything like you can when you only own one stock.
In 1968, a landmark study surprisingly concluded that you could eliminate the majority of your unsystematic risk with as few as 10 stocks*. In other words, if 10 properly selected stocks nets you as much diversification as you're going to get, why bother owning more?
This context is important because back then, an investor had to devote considerably more time and resources to managing a portfolio of stocks. Mutual funds didn't exist yet. The only game in town was to pick stocks. The issue was that the more stocks in the portfolio, the more a pain in the ass it the whole thing was to research and manage.
Fast forward a few decades. Diversification in the 80's and 90's was definitely for losers! At least that's the way it was portrayed. This was the heyday of the aggressive stockbroker cold calling you, claiming his firm had the best research and inside information to make you rich. Think Giovanni Ribisi & Vin Diesel in Boiler Room.
In recent times, the volatility of individual stocks has increased and the correlation of one stock's returns to another's has, on average, decreased**. Said another way, stock return swings are bigger now and fewer stocks do the same thing at the same time anymore (except 2008 when everything went to hell at the same time).
This phenomenon matters. It's harder to pick winners while simultaneously avoiding losers. The evidence for this reveals itself in the data. During a study period from 1983 through 2006***:
39% of stocks were unprofitable
18.5% of stocks lost at least 75% of their value
64% of stocks underperformed the Russell 3000 (US stock market benchmark)
25% of stocks were responsible for all of the market's gains
Based on the numbers, it's not realistic to believe anyone is smart enough to pick 10 winning stocks let alone call this strategy diversified. In fact, some recent studies have concluded that you should own more than 100 stocks to be diversified****. In essence, you need more stocks today to achieve the same diversification than you did a few decades back.
Some asset managers argue you need a few thousand stocks to be diversified. I'm mostly in this camp. The argument goes that if you want to max out your diversification efforts, you need to own at least a handful of stocks from every industry in every sector. Unpacking that statement, each of the ten S&P 500 sectors (healthcare, financials, energy, etc) has subcategories of industry within it. For example, the Industrials sector is made of Industries such as airlines, aerospace & defense, marine, and transportation, among others.
Overall, there are 85 different industries that fit within 10 sectors. Assuming 5 stocks in each industry for adequate diversification, that's 425 stocks. That's just in the United States. Now apply that same formula to every other developed economy in the world and throw in some emerging market economies for good measure. That's a recipe for thousands of stocks in your portfolio.
SO WHAT'S THE NUMBER?
I would challenge any investor to actually feel the difference between owning 3,000 stocks and 300. I don't think they could because the risk-adjusted benefit of all those additional stocks is so marginal. I recommend both depending on the client scenario. At my company, our core portfolio model consists of 7,191 underlying stocks throughout our chosen funds. Our least diversified portfolio holds 97 individual stocks as it's custom built based on a specific client's particular environmental & social vales and Smart Beta Factors.
I'm comfortable with the 97 stock strategy because I know the expected risk of the 97 individual purchased stocks is only a sliver higher than the core model with 7,191. Although 97 feels really low to me, I won't allow my bias towards a massively diversified portfolio dictate my emotions, and certainly not my professional recommendations to clients.
So how many stocks should you have? Unless you hold very specific reasons for deviating from the broader market (sustainability values, tilt towards high dividends, you hate Facebook, etc), you should always aim to capture as much of the market as possible. Based on the evolving research, at a minimum hold 100. Based on what you can get with super low cost index funds, you're probably going to own a few thousand stocks. Be happy with that.
Don't just assume that because you own a mutual fund you're diversified. For example, although I like the philosophy of Aspiration's Redwood Fund and Parnassus's Endeavor Fund, they only own a scant 25 & 31 stocks, respectively. That just doesn't cut it because at some point, unsystematic risk will rear it's ugly head and the funds will underperform much like each has recently.
If you're not sure what you own (or why for that matter), ask us for an analysis. It's no sweat off our back. Our technology allows for a clear picture of how much risk you're taking and how diversified you really are. You don't even have to hire us if you're not ready. You can even share the analysis with your current financial advisor, although I don't think you should and just hire us instead. But, that's biased :)