Diversification is arguably the most crucial concept in finance. Ray Dalio, the founder of hedge fund giant Bridgewater Associates, famously calls it "the holy grail of investing". Harry Markowitz, the pioneer behind Modern Portfolio Theory, celebrates diversification as "the only free lunch in finance" -- the only way for investors to reduce portfolio risk without sacrificing return.
While the importance of diversification is clear, its drawbacks are far less palpable -- and easy to miss. Is it truly a free lunch? Is it possible to have too much of a good thing -- and be over-diversified? Do you really need to own the entire market? Let's find out.
"Diworsification" -- being too diversified
Unfortunately, it turns out that it may be possible to have too many investments in your portfolio.
In his 1989 book "One Up on Wall Street", legendary investor and Fidelity Magellan Fund chief Peter Lynch expresses disdain for over-diversification. He calls it "diworsification" -- and notes that past a certain point, sticking additional investments in a portfolio may lead to worse outcomes.
Disappointingly, this occurs because diversification isn't immune from the law of diminishing marginal returns -- the insight that the diversifying benefit provided by an investment declines with each additional contribution.
For example, while adding another issue to a four-stock portfolio will do wonders for portfolio diversity, the 50th or 100th stock will contribute essentially nothing -- or might even harm the portfolio -- since the maximum benefit of diversification has already been acquired.
That said, over-diversification isn't necessarily deleterious to portfolio performance. While adding too many names to a portfolio can be sub-optimal, an over-diversified portfolio is still preferable to an under-diversified one; while the former risks underperformance, the latter risks ruin.
So, if you're to avoid both over and under-diversification, where's the sweet spot? What's the optimal number of holdings to have?
How many investments are enough?
Typically, you need between 10 and 30 stocks in a portfolio to be properly diversified, though the exact number is up for debate.
Value investors like Benjamin Graham suggested that 15-30 stocks were enough, while Fisher and Lorie (1970) found that 32 randomly selected, equal-weighted stocks were an excellent option.
However, critics like Surz and Price (2000) argue that proper diversification isn't just about the number of stocks in a portfolio -- it's also about how closely and consistently that portfolio tracks the broad market's performance -- and note that even 60 stocks aren't enough to diversify away tracking risk. Other detractors, like Bernstein (2000), go even further -- contending that "the only way to truly minimize the risks of stock ownership is by owning the whole market."
At the end of the day, there isn't a true consensus on the perfect number of stocks to have in a portfolio, and what one investor considers to be a properly diversified portfolio may be too risky for another. Like many things in investing, the "optimal" number of investments to hold is the number that best fulfills both your personal risk and return objectives.
So, should you own the entire market?
If you want assurance that you'll own a fraction of every publicly listed company -- everything from the next Apple (NASDAQ:AAPL) and Netflix (NASDAQ:NFLX), to every dying firm and eventual zero -- then it may be a good idea to buy a total market fund, like Vanguard's (NYSEMKT:VTI) -- for complete coverage.
At the same time, there are pragmatic reasons to own fewer stocks. If you hold just 15 names, you can afford to browse 10-Ks, listen to earnings calls, and read MD&A reports for each company in your portfolio -- something that's impossible to do if you own even 150 companies, let alone the 505 components of the S&P 500 or the 3,000+ publicly traded companies in the United States.
And frankly, S&P 500 index funds aren't that well-diversified anyway. Since the S&P 500 is a capitalization-weighted index, companies with larger market caps are weighted more heavily. As a result, the top five holdings in the S&P 500 account for nearly 21% of the index, and the top ten components make up nearly a third.
If you're looking for greater diversification, holding an equal-weight index fund -- or equal-weighting a limited selection of handpicked firms -- may be better bets. So long as you are shrewd and prudent in investing your money, you can stand to benefit from a well-funded retirement -- free lunch or not.