Diversification - How many stocks to own?

Diversification is a controversial topic. The academics advocate diversification while value investors advocate some for of concentration. In fact, Warren Buffet did say: Wide diversification is only required when investors do not understand what they are doing.

I won't say that i am right but i am am definitely of the opinion that diversification really can affect your investing results. To have better results, i feel that one must learn to pick their spots.

The sole purpose of diversification is to reduce non market risk which is risk inherent in a certain stock. An example of non market risk is fires in the company factory or when a particular product is not selling as well. This has to be differentiated from market risk. Market risk is the risk of being in the market. If the market drops, your portfolio drops as well and i doubt there is nothing you can do to aviod that kind of risk.

That being said, what is the optimum number of stocks that one should have in their portfolio? Statistics say that owning 2 stocks help eliminate the non market risk of owning just 1 stock. This risk is reduced by 72 % with 4 stocks in the portfolio and further reduced by 81 percent with 8 stocks. 93% is further shaved off with 16 stocks and, 96 % with 32 stocks and 99% with 500 stocks.

As you can see, you need not own many stocks. Above 8 stocks, diversification does not add much incremental benefit in the for of lowered non market risk. Hence i opine that 8 stocks is a good number. In fact, 6 - 10 is a great number to own. Another advantage of owning a lesser number of stocks is that you have more time to focus on the portfolio.



Cheers,
Lucas