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It's frustrating and true: Many of life's important questions don't have clear answers. For example, how many stocks should you own?
It would be great if the answer to the question were "one." Just think of it -- you'd pick it carefully, but then you'd only have one company to pay attention to. And if all went well, you'd build a big nest egg with it, for your retirement.
But many times, all doesn't go well. What if your one stock had been Enron?
12 -- no, 120 -- no, 500!
Clearly, owning just one stock is rather risky. You obviously shouldn't park all your eggs in a single basket. But it can be hard to figure out just how many baskets you need. The experts and their studies disagree:
- In Investment Analysis and Portfolio Management, business professors Frank Reilly and Keith Brown referred to a set of studies of randomly selected stocks that found "about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks."
- In The Intelligent Investor, Ben Graham suggests that investing in 10 to 30 stocks can offer adequate diversification.
- In The Journal of Finance in 1968, researchers Evans and Archer determined that you could reduce your portfolio's risk to nearly that of the overall market with just 10 securities.
- In 2002, Meir Statman found, "Today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 120 stocks."
I could list even more findings, with a wide range of results. Clearly, there's no major consensus.
Financial historian William Bernstein offers perhaps the most extreme view when contemplating a portfolio of 10 or 15 stocks: "Unfortunately, in investing, it is all too often true that the same things that maximize your chances of getting rich also maximize your chances of getting poor. ... The only way to truly minimize the risks of stock ownership is by owning the whole market." [Emphasis in original.]
There's a trade-off to consider. Own too few stocks, and you face the risk of disaster if one of them implodes. Own too many stocks, and you risk not being able to keep up with them all. Given all that, what should we small investors do?
What to do
Well, one way to hedge your bets is to mix both strategies. Put some of your money in a broad-market index fund, giving you gobs of diversification. Then, to aim for market-beating results, add a manageable number of compelling companies to your portfolio. That way, you'll benefit from great stock picks without having quite the risk you'd have putting all your money into individual stocks.
What number of stocks is right for you and your portfolio? Let us know -- leave a comment below!