Over the years, I’ve held many investment seminars. When I come to the topic of a diversified portfolio, I typically ask the crowd how many stocks each person owns. Many say 15 or 20, and a healthy number say 25, 30 or even 40. They’re all making a big mistake.
You really should be focusing on eight to ten stocks. Any more or any less and you’re hurting your returns or taking on too much risk.
You really don’t need any more than that to gain exposure to the broader stock market. And if you start packing in the stocks and carrying a portfolio with two dozen names, most of those holdings are likely to mimic the returns of each other. If you believe that demand for computer disk drives will rise next year, you don’t need to buy shares of several companies that have exposure to that trend. One solid investment will suffice.
Moreover, since buying and selling stocks creates transaction costs (such as bid-and-ask spreads), too many holdings likely means you’re total costs are too high relative to your returns.
So how do you create a well-diversified portfolio while cutting down on the number of holdings? A quick review of what diversification really means helps put it all in perspective.
What Defines Diversification?
The key to diversification is not simply owning a certain number of stocks -- it's all about covering your bases.
The key concept in building a diversified portfolio is to provide you with exposure to a range of industries and different types of companies and investments. For example, every portfolio should contain holdings in energy stocks, consumer goods companies, financial services companies and industrials.
Investors should also own a healthy mix of both large, stable companies and smaller, faster-growing companies. And they should be sure that their portfolio has exposure both to the U.S. and the rest of the world.
But you don’t want to own more stocks than you can keep track of. Luckily, by picking the right stocks, you can meet those needs with just a handful of companies.
For example, Ford Motor (NYSE: F) can provide exposure both to the industrial sector and to other economies. A well-run regional bank holding can help expose you to financial services and small caps. A stock like IBM (NYSE: IBM) provides exposure to high-tech and also brings the solidity of a blue-chip.
You can mix and match any number of stocks, but be sure that they are covering all the bases. If your portfolio is solely composed of 10 different tech stocks that are currently in high-growth mode, then you run the risk of seeing your portfolio slump if investors start to rotate out of tech stocks. In addition, those stocks are likely to move up or down in tandem, which makes you wonder why you’re not simply choosing the best idea in the group.
I’ve written in the past that investors have a much easier time assessing when to buy rather than when to sell. That’s why portfolios can creep up to 30 or 40 holdings over many years. The outcome is obvious. Once you own a few dozen stocks, you start to lose track of some of them and fail to notice that they are starting to trade poorly or that a rival to that invested company has announced major news.
It’s difficult to keep up with 20, 30 or even 40 different companies. As a rule of thumb, only invest in the number of companies that you have time to continually research. If that’s only three or four stocks, so be it. The rest of your investment dollars can go into a mutual fund.
[To learn more about diversification visit our InvestingAnswers Feature: Diversified Investments - Beginner's Guide to Protecting Your Nest Egg.]