Majority of Investors Drive their Portfolios without a Diversification Seatbelt

It’s a choice that’s nearly a matter of financial life or death. Deciding the right number of stocks to hold in your portfolio is a balance between risk and return – too few and your risk is high, too many and you might as well own a broad market fund or ETF. Research shows that the average active investor owns only two! That’s far too low. If you are managing a portfolio of stocks, to strike the right balance I suggest holding about 10 stocks at any time.

Your Stock Portfolio Should Balance Risk and Return

Two friends of mine pick stocks in very different ways; Fred spends a lot of time trying to find the one great stock to hold, while Martha just endlessly adds stocks. So, what is the “right” number of stocks to hold in a portfolio? To answer this, you need to think about finding the balance between risk and return.

Most people have their own “methodology” or “style” for picking stocks; one might be a value investor, another might be a growth investor. They narrow down a list of stocks to those that fit the style, and then look in detail at individual stocks. At the top of that list are the stocks that are a perfect fit. Fred just buys the top stock on that list, while Martha buys the top 20 or 30 stocks.

Fred has a portfolio focused on the success of one stock – but what happens if that company gets into trouble and the stock falls? He is taking a big risk. Martha has a portfolio with so many stocks that it behaves like the overall market, so she is lowering her chance of returns that “beat the market”.

The Average Investor in the US Holds too Few Stocks

Researchers Brad Barber and Terrance Odean wrote a well-known paper in 2000 after looking at approximately 60,000 individual brokerage accounts in the US. They uncovered a shocking fact – 50% of these investors owned only two stocks! Seventy five percent owned five or less. It turns out that the average investor in individual stocks behaves a lot like Fred. Later, research team Alok Kumar and William Goetzmann looked at the same data in even more detail and confirmed these conclusions.

Trade Smart – Diversify your Portfolio

My recent research in Asia tracks a long history of research into the right number of stocks to hold in an actively managed portfolio. My work suggests that a portfolio of 10 stocks is just about right for the average investor – somewhere between Fred and Martha. At 10 or more, you can claim to have a well-diversified portfolio. If you own any less than 10 stocks, like Fred, you are exposed to the risk that any one stock’s collapse can seriously damage your portfolio. As you go above 10 stocks, like my friend Martha, your portfolio starts to behave a lot like the overall stock market, in which case it would be better to save your time and just hold a broad market ETF. I often say that when an investor owns a well-diversified portfolio, it is like she is wearing a seatbelt. Almost everyone sees the safety benefits of seatbelts – and now you know the risk-reducing benefits of a well-diversified stock portfolio, as well.

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I would love to hear your thoughts! Any comments or question you might have, I would like to know. How many stocks do you hold in your portfolio? Do you agree or disagree with me? Is anything unclear? Please let me know in a comment below. 

 

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References:

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. (2000).

Kumar, Alok and Goetzmann, William N., Equity Portfolio Diversification (2004).

Stotz, Andrew and Lu, Wei, Ten Stocks are Enough in Asia (2014).