Welcome to our advanced investor education program. This is the first of a six-part series.
You've heard the expression "don't put all your eggs in one basket." The investing equivalent is: "don't put all your cash in one stock, or even one industry."
We've heard it over and over. If you want to make money and avoid big losses, you have to diversify, diversify, diversify. But how many stocks do you need for a well-diversified portfolio? Five? 50? 500? Is there such a thing as being too diversified?
Before we answer these questions, which are the subject of some debate, let's review what diversification can - and can't - accomplish. You can read a simple definition of diversification here and a more detailed one here.
As investors learned during the credit crisis, when the stock market gets really grumpy, no amount of diversification is going to save you. That's because diversification doesn't protect against "systematic" - or market - risk, which cuts across the whole economy.
Learn more about investing from John Heinzl The 2010 Investor Education series for beginner investors:
The 2010 Investor Education series for advanced investors:
Gail Bebee's weekly mentoring for our investor education contest winner:
What it does protect against is "unsystematic" risk, which is specific to individual companies or industries. By investing in a mixed bag of stocks and sectors, you spread your bets around, reducing the impact that any one stock or sector will have on your portfolio.
What's more, if you choose stocks that have a low or inverse correlation with one another - an oil producer and an airline, for example - you further reduce the volatility in your portfolio, because the stocks react in different ways to the same events (a change in oil prices, for instance).
By adding other asset classes such as real estate, bonds and commodities, you achieve even greater diversification.
How Much Is Enough?
Here's where the debate heats up. The legendary Ben Graham, in his 1949 book The Intelligent Investor , argued that a portfolio of just 10 to 30 stocks provides adequate diversification, and that adding more stocks produces only a marginal reduction in volatility (while increasing both transaction costs and the time needed to monitor the portfolio). Since then, several studies have produced similar results.
A classic 1968 paper by professors J.L. Evans and S.H. Archer, for example, concluded that a portfolio of 10 randomly chosen stocks would have similar risk, as measured by standard deviation, to the market as a whole.
More recently, studies have concluded that because of increasing volatility, a well-diversified portfolio should have 30 or more stocks.
Still, not everyone agrees that a few dozen stocks provide adequate diversification.
"To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperilling your financial future and the future of those who depend on you," William Bernstein, an investment adviser and author, said in a paper called The 15-Stock Diversification Myth.
Those are strong words. What's behind them?
The problem with a 15-stock portfolio is that, although it reduces day-to-day volatility, it also dramatically increases the odds that you'll trail the market over the long term. Why? Because you'll be less likely to own the huge gainers - Mr. Bernstein calls them "superstocks" - that drive much of the market's returns. Think of stocks such as Potash Corp. and Research In Motion Ltd.
He cites a study that, from 1980 to 2008, the top 25 per cent of U.S. stocks were responsible for all of the market's gains. The bottom 75 per cent of stocks actually posted a negative annual return over the same period.
So if you own just 15 or 30 stocks, "you've got a good chance of not getting one of those superstocks, and then you've lost the game," Mr. Bernstein, author of The Four Pillars of Investing , told me in an interview.
What's an investor to do? Well, you could spend every waking hour managing a portfolio of, say, 500 stocks. Or you could take the simpler route and buy an index fund that tracks the entire market.
"Theoretically, everybody in the world should own the world market portfolio," Mr. Bernstein said. You can't get more diversified than that.