First off, there is no single correct answer to this question—it will depend on a number of factors such as your country of residence and investment, your investment time horizon and your propensity for reading market news and keeping up-to-date on your holdings.
Investors diversify their capital into many different investment vehicles for the primary reason of minimizing their risk exposure. Specifically, diversification allows investors to reduce their exposure to what is referred to as unsystematic risk, which can be said to be the risk associated with a particular company or industry. Investors are unable to diversify away systematic risk, such as the risk of an economic recession dragging down the entire stock market, but academic research in the area of modern portfolio theory has shown that a well-diversified equity portfolio can effectively reduce unsystematic risk to near-zero levels, while still maintaining the same expected return level a portfolio with excess risk would have.
In other words, while investors must accept greater systematic risk for potentially higher returns (known as the risk-return tradeoff), they generally do not enjoy increased return potential for bearing unsystematic risk. The more equities you hold in your portfolio, the lower your unsystematic risk exposure. A portfolio of 10 stock, particularly those of various sectors or industries, is much less risky than a portfolio of two. Of course, the transaction costs of holding more stocks can add up, so it is generally optimal to hold the minimum number of stocks necessary to effectively remove their unsystematic risk exposure. What is this number? There is no consensus answer, but there is a reasonably certain range.
For investors in the U.S., where stocks move around on their own more (are less correlated to the overall market) than elsewhere, the number is about 20 to 30 stocks. Predominant research in the area was conducted prior to the revolution of online investing (when commissions and transaction costs were much higher), and most research papers put the number in the 20–30 range. More recent research suggests that investors taking advantage of the low transaction costs afforded by online brokers can best optimize their portfolios by holding closer to 50 stocks, but again there is no consensus.
Keep in mind that these assertions are based on past, historical data of the overall stock market, and therefore does not guarantee that the market will exhibit the exact same characteristics during the next 20 years as it did in the past 20. As a general rule of thumb, however, most investors (retail and professional) hold 15–20 stocks at the very least in their portfolios. If you are intimidated by the idea of having to research, select and maintain awareness of about 20 or more stocks, you may wish to consider using index funds or ETFs to provide quick and easy diversification across different sectors and market cap groups, as these investment vehicles effectively let you purchase a basket of stocks with one transaction.
Russell Wayne, CFP®
Sound Asset Management Inc., Weston, Conn.
The number of stocks in a portfolio is in itself unimportant. That's because a portfolio could be concentrated in a few industries rather than spread across a full spectrum of sectors. In such a case, you could hold dozens of stocks and still not be diversified. If, on the other hand, the stock holdings were diversified over a wide variety of industries, two or three dozen should be sufficient. Here, too, proper stock selection will make a big difference. It usually helps to focus on the stronger players in each industry in order to take advantage of the potential that each industry provides. Look at the components of the Dow Jones Industrial Average: Those are 30 of the best-known names in the U.S. corporate world.