How many stocks should an investor own in order to diversify away stock-specific risk? Some interesting data shows that it may be fewer than you think.
The data comes from hedge fund guru Joel Greenblatt’s book, You Can Be A Stock Market Genius, and was highlighted by top value investor Whitney Tilson a few years back (and recently reprinted on The Motley Fool website). According to Greenblatt’s book, the risk-reduction benefits of adding more stocks to your portfolio significantly decreases once you get to about 20 or so stocks. Tilson, citing the data, said that “owning two stocks eliminates 46% of nonmarket risk of just owning one stock.” As you add stocks to the portfolio, that nonmarket risk declines as such:
• Owning four stocks eliminates 72% of the risk
• Owning eight stocks eliminates 81% of the risk
• Owning 16 stocks eliminates 93% of the risk
• Owning 32 stocks eliminates 96% of the risk
• Owning 500 stocks eliminates 99% of the risk
“Generally speaking, my ideal portfolio would have 12-20 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), of which roughly five were 10% positions and rest were 5-9% positions,” Tilson wrote. “Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there’s obviously a big penalty in terms of performance if one’s best ideas are 3-5% positions instead of 7-10% positions.” (Keep in mind that Tilson’s artice was published in 2004, so his approach may have been altered since then.)