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How many shares make a diversified portfolio?

William Ryder, Equity Analyst, digs into the theory behind diversification and looks at how many stocks investors should hold.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

There are two types of risk when holding shares.

The first is the general risks of shares as an asset class. That’s the risk that all shares go down at the same time, as was the case earlier this year. Between 20 February and 20 March only two shares in the FTSE 100 had a positive return, and only seven avoided falling by more than 10%. No amount of diversification among shares would have prevented your portfolio from losing value. We call this “market risk”, the risk that the entire stock market falls.

The second type of risk is stock specific. The individual company you own could run into problems, perhaps because its competitive position has weakened or it’s been particularly badly damaged by the pandemic. This is the type of risk diversification can help with.

So how many shares do you need to hold to be properly diversified?

This article isn’t personal advice. If you’re at all unsure please ask for advice. Investments rise and fall in value, so you could get back less than you invest.

The academic view

Academics have been engaged in a lively and long running debate on the subject of diversification for decades now, and there doesn’t seem to be strong consensus. Answers range from between 10-15 shares all the way up to 300 depending on the assumptions each researcher makes.

However, while the exact number is hard to pin down, we can pull out some important guiding principles from the academic literature.

  1. The benefits of diversification are subject to the law of diminishing returns.
  2. We want as much diversification as we can get until the marginal costs outweigh the marginal benefits.

Diminishing returns

The law of diminishing returns means that the second and third shares you add to your portfolio give much greater diversification benefits than the 100th share.

The graph below shows the theoretical amount of share specific risk (not market risk) that’s eliminated by portfolios of different sizes. Remember, it’s only the share specific risk that can be reduced through diversification. The market risk is always there regardless of how many companies you own.

Chart showing the diminishing returns of diversification

Source: Tang, ‘How efficient is naive portfolio diversification?’ 2004.

Marginal costs

The diversification benefits of holding more shares diminish as you add more to your portfolio. So in theory you should keep adding more shares until the costs outweigh the benefits.

These costs don’t just include charges like trading commissions, there’s also the time involved. Most of us have jobs, families and other things to fill our time besides poring over company accounts. Keeping track of a large share portfolio, and hunting for ideas, can be a full time job - this is where a fund manager could help. At a certain point, the diversification benefits just don’t justify all that extra effort.

The case for concentration

Many famous stock pickers have a different view on diversification. The logical end point for what I’ve called the academic view is to buy a broad index fund. But an index fund is only ever going to match the market, because it offers only market risk and market returns (less fees).

If we’re picking shares, instead of buying an index fund, presumably we’re trying to beat the market – not just match it.

The more shares you hold in your portfolio the more it’s going to resemble the index, and so your chances of either outperforming or underperforming fall too. By the same stroke, the more concentrated your portfolio the more it is likely to perform differently to the index.

This means that if we’re trying to beat the market we need to hold a more concentrated portfolio. Fortunately, you can gain a lot of diversification benefits by holding relatively few shares, as shown in the graph above.

So how many shares should you hold?

The academic answer would be as many as you can keep track off. We all have different demands on our time, so the exact number will depend on your personal circumstances.

The stock picker’s answer would be to focus on your best ideas, and avoid diluting your portfolio with shares you don’t really believe in.

How many you hold will depend on your confidence in your share picks and your tolerance for risk and volatility.

It’s also important to remember that the type of share will determine the level of diversification benefits you get. For example, you gain relatively little diversification by investing in all four of the UK’s large banks or supermarkets. Holding one bank and one supermarket will give more diversification benefits than holding four of either.

Core-Satellite approach

One way to diversify a portfolio is the core-satellite model.

Funds are a portfolio of shares (or other assets), and can form the core of a portfolio. A broad global index tracker could serve this role, or you could choose a few actively managed broad funds pursuing different strategies and investing in different assets.

This core can then be added to with individual satellite shares or more specialist funds. This approach allows you to hold a diverse portfolio, even if you only have the time to do research on a few individual shares.

Read more about the Core-Satellite approach

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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