Worried about a correction? Buy more stocks

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Worried about a stock market correction? You may need more stocks to lower the risk level in your portfolio, not fewer.

Classic thinking on diversification suggests that as few as 15 to 20 different stocks will provide effective diversification. But a recent note from the research department at PWL Capital quotes some work by a pair of finance professors that shows optimum diversification in the Canadian market requires up to 70 equally weighted securities. If that's the case, "then it stands to reason that a global portfolio would require thousands of stocks to achieve its diversification potential, considering there are about 50 developed and emerging countries in the investable world," PWL research chief Raymond Kerzérho wrote.

Portfolio managers measure risk using standard deviation, which typically looks at ups and downs in a security's monthly returns. Finding the ideal diversification level for a portfolio is a matter of adding randomly selecting stocks one by one until most of the standard deviation is reduced, Kerzérho writes. Back in the 1950s, this process led to the belief that 20 or so stocks were enough to diversify a portfolio.

The multiple stock market crashes of the past few decades have called this thinking into question, though. Another flaw in standard deviation of monthly returns is that long-term risks are not addressed. Kerzérho said he prefers the view on risk found in a new research paper by Francis Tapon of the University of Guelph and Vitali Alexeev of the University of Tasmania. They found that to best reduce risk in short-term and long-term cumulative returns, the 70-stock portfolio works better in the Canadian market.

In a roundabout way, these two professors have highlighted exchange-traded funds as an effective investing tool. ETFs are most often praised for their low costs. But the diversification they offer by tracking entire stock indexes is a big benefit as well. Canada's largest ETF, the iShares S&P/TSX 60 Index ETF gives you a 60-stock slice of blue-chip corporate Canada. If you wanted the equal weight approach suggested by Tapon and Alexeev, then check out the Horizons S&P/TSX 60 Equal Weight Index ETF.

Looking for the thousands of holdings that Kerzérho talks about for global investing? Try something along the lines of the Vanguard FTSE Developed ex North America Index ETF, with 1,374 holdings, and the Vanguard U.S. Total Market Index ETF, with 3,690 holdings. By adding more stocks to your portfolio through an ETF, you could actually be cutting risk.