The number of stocks that should be in your portfolio is a personal decision that will vary from investor to investor. Certainly, it’s clear that some level of diversification is healthy to keep down portfolio risk while still offering higher returns. But just as apparent is the fact that there can be too many or too few stocks in a portfolio to achieve an appropriate risk/reward balance. So, how many stocks should be in your portfolio? Read on to learn how to make the right choice for you.
What Is An Optimal Amount of Stocks in a Portfolio?
Although the so-called “optimal amount” of stocks is a nebulous, non-universal number, many financial advisors and even mathematicians feel that somewhere between 20 and 30 stocks could be the best option. This way, no more than 3% to 5% of your portfolio would be allocated to any single stock, which can greatly reduce your volatility risk. However, some experts recommend as many as 60 stocks in a portfolio to achieve total diversification. The reason a specific number is hard to nail down is that it isn’t just the number of stocks that create diversification, it is also the types of stocks you buy.
What Are the Four Types of Stocks, and How Do They Play Into Portfolio Diversification?
There are many different stocks, but for purposes of diversification, they can be divided into four main categories: income, growth and income, growth, and speculation.
Income stocks pay out relatively high regular dividends but don’t offer much potential for growth. Preferred stocks are a good example, as are many exchange-traded funds that invest in income-generating investments.
Growth-and-income stocks pay decent dividends and also offer the potential for growth. They won’t generate as much income as straight income stocks, and their growth opportunities may not be as high as true growth or speculative stocks. But they can offer access to the stock market that may be a bit more conservative than with other types of stocks.
Growth stocks are the bread and butter of the overall stock market, offering potential for high long-term returns at the expense of casting off no income to shareholders. Generally, growth stocks are in less-mature industries that offer the potential for more explosive returns than older growth-and-income stocks.
Speculative stocks offer both high risk and high reward. These types of companies may be in boom-or-bust industries like pharmaceuticals or they may only have a single product, meaning their fortunes are of the make-or-break variety. While potentially offering punch to your portfolio, they also may cost you your entire investment.
Diversification Among Industries
Just as a truly diversified portfolio has stocks of different types, it should also have companies from different industries. If, for example, all you own are technology stocks, even if you put 100 of them in your portfolio, you won’t be diversified. A selloff in the tech sector will likely drag all of those stocks down, even if the broader market roars higher. The whole idea behind diversification is that if a certain segment of the market is falling, you want to own some stocks that are in the other sectors that are rising. To that end, most experts recommend adding stocks from technology, consumer goods, energy, finance, healthcare and so on if you’re looking to truly diversify your portfolio.
Pros and Cons of Many Stocks in a Portfolio
The main benefit of having many stocks in a portfolio is that if one of them loses a significant amount of money, you won’t lose all of your money. With a portfolio of 20 equally weighted stocks, even if one of them loses its entire value, your portfolio will only drop by 5%, all other things being equal.
Although having many stocks can reduce the risk of any single stock, it doesn’t protect you from a bear market. Having too many stocks can also be cumbersome to manage, and it can also cost you more if you work with a broker who charges commissions on every trade.
Pros and Cons of Few Stocks in a Portfolio
Having just a few stocks in your portfolio can generally offer higher potential returns than if you have a multitude. In a five-stock portfolio, for example, if one takes off and doubles, even if the rest of your portfolio is flat you’ll end up with a total return of 20%. In other words, if you’re a good stock picker and can avoid major missteps, a smaller portfolio could boost your returns. It’s also easier to manage a portfolio that just has a handful of stocks.
The primary con to having only a few stocks is that it only takes one bad stock to cause some real damage to your portfolio. Using the above example, if you have one stock that loses its entire value, your whole portfolio will decline 20%, even if your other stocks remain flat. Using a perhaps more realistic example, if you have four stocks that rise 10% and one stock that’s down 40%, your portfolio will sport a net 0% return. While that may not seem like much of a difference, it could be crippling to your long-term returns.
So, How Many Stocks Should Be in Your Portfolio?
The key to determining the “correct” number of stocks in your portfolio depends on your personal investment objectives and risk tolerance. Younger investors, who have more time for a portfolio to recover from a dip, can generally afford to get by on fewer stocks in a portfolio. As you get older, however, protecting your portfolio from major drops is as important as generating growth from a stock-heavy portfolio.
The more aggressive of an investor you are, the fewer stocks you can maintain in your portfolio. However, you have to truly understand the nature of risk. Just one or two bad apples in a portfolio of five or even 10 stocks can ruin your overall return, although the converse is also true. But if you want a portfolio where you can sleep more soundly at night, knowing that one or two bad picks aren’t going to derail your retirement savings plan, for example, you’d likely want to look at a portfolio with at least 20 stocks.
Talk with your financial advisor and really try to nail down what your investment objectives and risk tolerance are. Then, use that information to help you select an appropriately diversified portfolio.
Information is accurate as of Sept. 21, 2022.