How Many Stocks Diversify Unsystematic Risk?

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How Many Stocks Diversify Unsystematic Risk?

Once you own a certain number of stocks, you have eliminated all the unsystematic risk. When you have reached this point, there is no need to own any more stocks to diversify your risk of concentration, that is, the unique risks associated with any one stock. So how many stocks do you need to own to reach that point?

And the magic numbers are ...

Let’s hear from the experts. In their book Investment Analysis and Portfolio Management, Frank Reilly and Keith Brown reported that in one set of studies for randomly selected stocks, "… about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks." In other words, if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.

Essentially, the theory says that if you are properly diversified, on average, you will get the same return in the market as if you had bought a passive market index. So if you want to obtain a higher return than the markets, you increase your chances by being less diversified. At the same time, you also increase your risk.

It is also important to note that if you own more than 18 stocks, you will have achieved almost full diversification, but now you will just have to keep track of more stocks in your portfolio for not much marginal benefit.

When too much diversification hurts

While much of academia has focused on the risk of not being diversified enough, there’s also a practical risk to being too diversified. When you own too many companies, it becomes nearly impossible to know your companies really well. Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the 10-K, skip on investigating the firm’s second competitor, and so on. When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor. Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.

Non-market risk and a concentrated portfolio

Interestingly, holding a concentrated portfolio is not as risky as one may think. Just holding two stocks instead of one eliminates 46% of your unsystematic risk. Using a twist on the 80/20 rule of thumb, holding only eight stocks will eliminate about 81% of your diversifiable risk.

What about range of returns? Joel Greenblatt in his book You Can Be a Stock Market Genius explains that during one period that he examined, the average return of the stock market was about 10% and statistically, the one-year range of returns for a market portfolio (holding scores of stocks) in this period was between negative 8% and positive 28% about two-thirds of the time. That means that one third of the time, the returns fell outside this 36-point range.

Interestingly, Greenblatt noted that if your portfolio is limited to only five stocks, the expected return remains 10%, but your one-year range expands to between negative 11% and positive 31% about two thirds of the time. If there are eight stocks, the range is between negative 10% and positive 30%. In other words, it takes fewer stocks to diversify a portfolio than one might intuitively think.