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How Many Stocks Should Be in Your Portfolio? by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research April 2, 2008 Reprinted from the Spring 2008 edition of On Investing, a magazine for Schwab clients. For investors planning to manage a stock portfolio, a basic question is, "How many should I hold?" To be well diversified, the answer may surprise you. The wisdom of the old adage, "Don't put all your eggs in one basket," is especially relevant to equity investing. Yet many investors fail to diversify. In the excitement of searching for big winners, we forget the fate of investors who thought they'd found "the next Microsoft" in the shares of Enron or WorldCom. Or we believe risk can be minimized by carefully researching a few companies, forgetting that knowledge about a company doesn't ensure market-beating stock selection. Behavioral finance researchers have found that investors are often lured by high potential payoffs and tend to be overconfident in their forecasting ability, both of which can lead to poor decision making. Diversification is critical in the stock market because the uncertainty about the prospects of any single stock is extremely high. Proper diversification can help minimize portfolio damage from a bad stock pick and maximize the likelihood that your portfolio performance reflects your stock selection skill. Stock risk vs. portfolio risk Let's attempt to quantify the importance of diversification. Financial experts usually define investment risk as return volatility over time. All stock investors experience portfolio volatility stemming from equity market risk. But investors holding individual stock portfolios incur further risks. One respected study attributed the typical individual stock's volatility to three sources:
 Let's gain a deeper understanding of Figure 1. Say you randomly selected 18 stocks in equal proportions. The chart indicates that your portfolio's standard deviation would be about 10% relative to the overall market. For all you non-statisticians, think of the area under a bell-shaped curve. A standard deviation of 10% means that your portfolio's return would be plus or minus 10% of the mean or average of the distribution about 68% of all years. So if the market returned 10% in a year, you could expect your portfolio's return to be between 0% and 20% about 68% of the time—and that 16% of the time your portfolio would actually lose money! Reducing portfolio risk From my experience, most individual investors would assume 18 stocks are enough to be adequately diversified. If you share that belief, Figure 1 must come as a shock. Fortunately, the solution to reducing portfolio risk is simple—own more stocks! However, for your portfolio to closely track a market benchmark like the S&P 500 Index, your portfolio's composition must resemble the benchmark. Neither a volatile portfolio of 50 small tech stocks nor a more stable portfolio of 50 large-cap utility stocks will track the S&P 500 closely because both portfolios are undiversified. As a rule of thumb, we recommend holding at least 40 stocks in your portfolio. If you don't have the capital or commitment to manage a portfolio this large, mutual funds can be a convenient alternative. Avoiding losses Many investors prefer a simpler definition of risk: the probability of losing money. Of course, the problem with this definition is that you can't really manage equity market risk. If the market drops 20% in a year, your stock portfolio is almost certainly going to lose money as well. Nonetheless, the benefit of holding more stocks still applies. A broadly diversified stock portfolio is less likely to lose money in a given year than a highly concentrated portfolio (see Figure 2).
Another way to reduce the risk of losing money is to become a more skillful investor. If you employ a stock selection discipline that outperforms the market over time, the probability of losing money in a year is reduced. For example, stocks that are A-rated by Schwab Equity Ratings have historically outperformed the average Schwab-rated stock by over 4% annually. (See Schwab Equity Ratings performance.) Figure 2 shows how the probability of negative returns falls when portfolio size increases and when stock selection skill is present. Conclusion Portfolio diversification is perhaps the only "free lunch" in investing, as it reduces expected risk without reducing expected returns. But patience is another important risk management tool. Stocks are very volatile, so it's unreasonable to expect to beat the market every year no matter how much stock selection skill you, your advisor, or your fund manager possesses. Luck and skill are difficult to differentiate over less than a complete market cycle. To the extent that one year's underperformance reflects some bad luck, the next year's performance may benefit from some good luck. Don't let normal portfolio volatility tempt you to mistakenly deviate from your long-term strategy! Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Past performance is no guarantee of future results and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. Schwab Equity Ratings are assigned to approximately 3,000 of the largest (by market capitalization) U.S.-headquartered stocks using a scale of A, B, C, D and F. Schwab's outlook is that A-rated stocks, on average, will strongly outperform, and F-rated stocks, on average, will strongly underperform the equities market over the next 12 months. Schwab Equity Ratings are not personal recommendations for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Diversification strategies do not assure a profit and do not protect against losses in declining markets. The information provided is for general informational purposes only and should not be considered as an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Past results are not indicative of future performance. (0308-3982) Return to Top |
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