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Understanding the ideal number of stocks in a portfolio

valid until: 24 Sep 2021date published: 24 Sep 2020

Investors diversify their capital into many different investment vehicles to minimize their exposure to risk. In particular, diversification allows investors to reduce their exposure to so-called ad hoc risk, which can be defined as the risk associated with a particular company or industry.

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Investors cannot diversify systematic risk, such as the risk of an economic recession that will drag the entire stock market down, but academic research in modern portfolio theory has shown that a well-diversified stock portfolio can effectively reduce non-systematic risk to near zero levels while maintaining the same expected level. return, which would have a portfolio with excess risk.

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In other words, although investors must accept higher systematic risk for the sake of potentially higher returns (known as a trade-off between risk and return), they generally do not take advantage of the increased potential for return due to non-systematic risk.

The more stocks you have in your portfolio, the less you are exposed to random risk. A portfolio of 10 stocks, especially from different sectors or industries, is much less risky than a portfolio of two stocks.

Of course, the transaction costs associated with holding more shares can increase, so it is usually optimal to keep the minimum number of shares necessary to effectively eliminate their ad hoc risk exposure. What is this number? There is no consensus, but there is a reasonable range.

For investors in the United States, where stocks move on their own (less correlated with the market as a whole) than elsewhere, the number is between 20 and 30 stocks. The predominant research in this area was conducted before the online investing revolution (when fees and transaction costs were much higher), and most research papers range from 20 to 30.

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A well-diversified stock portfolio can effectively reduce ad hoc risk to near zero while maintaining the same expected rate of return as an excess risk portfolio would have.

More recent research suggests that investors taking advantage of the low transaction costs provided by online brokers can best optimize their portfolios by holding around 50 shares, but again there is no consensus.

However, as a rule of thumb, most investors (retail and professional) hold at least 15 to 20 shares in their portfolios. If you are intimidated by the idea of researching, selecting and maintaining awareness of about 20 or more stocks, you may want to consider using index funds or ETFs to provide quick and easy diversification across different sectors and market cap groups as these investments Vehicles allow you to buy a basket shares in one transaction.

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