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How Many Stocks Would You Need?

Portfolio diversification goes far beyond a simple “safety in numbers” concept

As an investor, price declines for the securities you own, even if they are just paper losses, are generally unwelcome events. Still, in a generic, equally weighted portfolio of 20 stocks, a 10% drop in price for one individual holding results in only a 0.5% decline for the overall portfolio. Of course, portfolio diversification goes far beyond a simple “safety in numbers” concept. The goal of diversification is that the stocks in your portfolio won’t all move in tandem—some will zig while others zag, decreasing the risk for the overall portfolio.

Keeping Your Eggs in Different Baskets

It’s important, however, to clarify which risks can be addressed via diversification: Systematic risk represents the overall stock market risk that investors cannot escape for the equity portion of their portfolios. Such risk can in theory be hedged via exposure to other asset classes. Yet in isolation, the market risk is still there, and hedging strategies often provide less benefit than expected. Unsystematic risk is the unique risk associated with an individual security, such as an unexpected roof collapse in a particular salt mine, which can be offset somewhat by assembling a portfolio of stocks. Diversification doesn’t provide a guarantee—it may reduce risk, but it doesn’t ensure a profit for investors or protect against losses in a declining market.

How many stocks are necessary to achieve sufficient diversification of this unsystematic risk? As you would expect, increasing the number of holdings in your portfolio generally decreases its volatility, as measured by the standard deviation of the portfolio’s returns. Yet multiple academic studies have shown that the incremental decrease in risk quickly falls off as the number of portfolio holdings increases. This reduction begins with a smaller number of holdings than you might think.

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