How Diversified Do Your Stock Investments Need To Be?

How Diversified Do Your Stock Investments Need To Be?

One key watchword in the investment world is diversification. I suspect that a large majority of investors would probably agree as to the importance of this approach for managing investment risk as well as the risk of running out of money in retirement. In our firm’s case we diversify not just across different asset classes but also within each one. Our clients are invested in all 3,500 U.S. stocks and in over 13,000 stocks globally. But have you ever wondered what the minimum number of stocks you’d need to hold is in order to be sufficiently diversified?

I reported in 2017 that Hendrik Bessembinder of Arizona State University discovered that the entire gain in the U.S. stock market since 1926 was attributable to just the best-performing four percent of listed stocks. (Here’s the link: https://www.cognizantwealth.com/2017/05/17/new-study-picking-stocks-is-a-losing-bet/ ). If we assume that same percentage of stocks provides all the gains in any given year, all we’d need to do is invest in those 140 U.S. stocks not only to be well-diversified but also to ensure we get the greatest possible return from the stock market. Right?

Not so fast. Which 140 stocks would you choose? You see, it’s not the same 140 stocks that capture all the gains from one year to the next. And if only 140 stocks experienced gains last year, then over 3,300 didn’t. Which means that a large majority incurred losses. If you pick just 140 stocks to represent the broad market, you have only a 4% chance of holding the right ones.

What if you chose 280 stocks instead? That would double your chances of a gain. But 8% is still probably not what you’d consider to be good odds.

You see where this is heading? The only way to ensure that you hold all 140 positive-returning stocks is to invest in the entire U.S. market of 3,500 publicly-traded companies. Even investing in only 3,400 of them risks missing some of the winners. There are certainly investors, mutual fund managers, and even investment advisors who claim to be able to pick the winners from the losers. I have yet to come across anyone who has been able to do so consistently from year to year over a long period of time no matter what methodology they applied. If you flip a coin ten times you might get ten heads in a row. But that’s still just luck, not skill.

The good news is that there are dozens of mutual funds and ETFs that invest in entire asset classes such as U.S. stocks at an extremely low cost. It is very easy today to invest in a total asset class such as the U.S. stock market. You won’t beat the market by doing so. But then again, why would you want to?

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