Industry rules-of-thumb often state that 15 to 30 stocks are enough for a well-diversified portfolio. This can be very misleading.
Recent studies point out that industry rules-of-thumb on the number of stocks needed for a well-diversified portfolio are simply not adequate. These rules-of-thumb most often state that 15 to 30 stocks are enough. “The Truth About Diversification by the Numbers” by Ronald J. Surz and Mitchell Price of Roxbury Capital Management is an insightful study on the “how many stocks” question.1 (See: Can a limited number of equities provide complete portfolio diversification?) To determine the number of stocks required to achieve a desired level of portfolio diversification, Surz and Price computed all possible combinations of NYSE and NASD traded stock portfolios of various sizes for the 1986 to 1999 period. They argued that a diversification rule-of-thumb commonly used in investment management – that 30 randomly chosen stocks will achieve 95% of diversification – is inadequate. Using tests of statistical significance and market tracking error, Surz and Price found that the number of stocks required to achieve diversification is much higher than commonly thought. Surz and Price found that the average randomly chosen 30-stock portfolio achieved only about 85% of possible diversification. A 60-stock portfolio achieved about 88% of possible diversification. Using computer optimization techniques and favoring large capitalization stocks both helped to improve portfolio diversification, when compared with randomly selected portfolios.
Price volatility at the individual common stock level has increased substantially in recent years.
This factor and the fact that the correlation of price volatility between individual stocks has also declined, means that significantly increased numbers of stocks are required to achieve diversification. The number of stocks required is very large, and this makes index mutual fund and exchange-traded fund investment alternatives increasingly appealing. (See: Why is diversification valuable to individual investors?) Properly selecting and managing a personal stock portfolio is not a casual affair. The individual investor who intends to self-assemble a well-diversified portfolio with a relatively large number of equities has a huge challenge. Personal time commitments, financial analysis skill/experience, relative costs versus mutual funds, and the availability, quality, and cost of financial information remain significant issues for the do-it-yourselfer. For those who rely on full-service brokers for advice, very important additional considerations are additional broker fees and whether the broker even believes that maintaining a well-diversified portfolio is important just as long as you keep trading [...]