This article appeared first on The Stock Market Blueprint Blog.
In a previous post, I discussed four simple steps to help you create your own investment strategy. The first step was to select the stock screen you want to follow. The second step was to choose how many stocks you will own.
Last week’s post went into detail regarding the first step. In this post, we’ll go into further detail regarding the second step.
Diversification Is Essential
Diversification is an essential part of any investment strategy. There are too many unknowns when investing in the stock market to put all your eggs in one basket.
If too much of your portfolio is allocated to just a few stocks, the consequences could be drastic. On the other hand, if your investments are spread across too many stocks, your returns could suffer.
Here's what we said about diversification in the original post:
As an individual investor building your own portfolio, you have the luxury to choose how many stocks you will own. Investors who buy mutual funds or ETFs don’t have the same ability.
Academic studies have shown that as little as 10 to 15 stocks is enough for any portfolio to reduce unsystematic risk.
Once a portfolio owns only 10 stocks, the volatility is essentially identical to that of the S&P 500.
Many experienced investors recommend investment strategies consisting of 10 to 30 stocks.
More than 30 becomes too difficult for an individual to manage and provides little upside potential. Less than 10 doesn’t cast a wide enough net to capture winning stocks and exposes the portfolio to too much risk.
When you create your own investment strategy, you’ll need to choose how many stocks you will own depending on your personal preference.
Adequate Though Not Excessive
Conventional wisdom says that a highly diversified portfolio is a critical component to any investment approach. Warren Buffett has said diversification is a hedge against ignorance.
In The Intelligent Investor, Benjamin Graham recommends “adequate though not excessive diversification.” The trick for individual investors is to find the sweet spot between too little and too much diversification.
Limiting volatility is the number one reason investors choose to diversify. Interestingly though, academic studies have demonstrated that owning just 10 or 15 uncorrelated stocks drastically reduces unsystematic risk, i.e., volatility, in a portfolio.
Volatility isn’t as big of a threat as popular sentiment makes it out to be. There are more practical reasons to diversify.
Maximize Returns, Minimize Loss
In addition to reducing unsystematic risk, greater levels of diversification minimizes the possibility of total loss. Moreover, more investments mean a higher probability of capturing “winners” that significantly impact returns.
Even so, there is a risk in over-diversifying. Owning too many investments increases the probability that the returns of the “losers” will drown out those of the “winners.”
Choose How Many Stocks You Will Own
The number of stocks an investor should own depends entirely on the type of analysis he performs and his level of knowledge.
Warren Buffett can get away with claiming that diversification “doesn’t make sense if you know what you’re doing” — because he’s Warren Buffett.
But in general, individuals following quantitative strategies should own large “buckets” of 10 to 30 stocks.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.