Table of Contents
Introduction to Diversification Myths
You might remember Jim Cramer on CNBC's Mad Money with his 'Am I Diversified?' segment, where viewers called in with their top five holdings, and he'd tell them if they were diversified. But let's be real—that idea of diversifying with just five stocks is way too low, and even the stock-picking crowd pushes for around 30, which still falls short.
I've long known that diversification cuts your portfolio risk and can even boost returns, but the big question is how many stocks you really need for maximum diversification. The rule of thumb says 30 stocks across sectors does it, but is that accurate? Stick with me as I break it down.
Key Takeaways on Diversification
Diversification does reduce risk, but hitting 100% isn't always possible. To get maximum diversification, you have to think global—covering all sectors, styles, and thousands of stocks. Remember, chasing lower risk might mean missing big wins. That's where low-cost funds and ETFs shine, offering better diversification than picking stocks yourself.
Where Does the 'Magical' Number 30 Come From?
Back in 1970, Lawrence Fisher and James H. Lorie published a study in The Journal of Business on how more stocks reduce return variability. They showed a random 32-stock portfolio cuts risk by 95% compared to the whole NYSE. From there, the legend grew that 30 stocks capture 95% of diversification benefits.
Of course, no serious investor admits to random picks, so managers tweak it to say they select the 'best' 30 for max diversification and market returns. They might show you a chart like Figure 1, plotting risk against stock count. But honestly, that's not the full story—it's not true diversification.
Risk Reduction Isn't True Diversification
The Fisher and Lorie study focused on risk via standard deviation, not actual diversification. A newer study by Surz and Price used better metrics like R-squared (how much variance ties to the market) and tracking error (return variance vs. benchmark). Their Table 1 reveals that 60 stocks only hit 86% diversification for U.S. large caps.
Keep in mind, that's just for one market. When building your portfolio, you need to diversify globally. And don't forget opportunity cost—focusing too much on risk means you might miss top performers, as shown in Figure 2 for 2010's styles, sizes, and regions.
What True Diversification Requires
To capture market returns and cut risk properly, you need the whole global market, including dimensions like domestic/foreign, growth/value, small/large, plus emerging markets. On top of that, diversify across industries like telecom, utilities, energy, and more.
You also have to own future winners, but studies like Crittenden and Wilcox's on the Russell 3000 from 1983-2006 show it's tough: 39% of stocks lost money, 18.5% dropped 75% or more, 64% underperformed, and just 25% drove all gains. Figure 3 visualizes this skewed distribution.
The Realistic Minimum for Stocks
Ask yourself: How likely are you to pick the next Microsoft early? The global universe is massive. Even for one sector like energy, you'd need multiple stocks to avoid disasters—say, five per area. With over 200 industries, that's at least 1,000 stocks minimum.
But building that? It's impractical: biases creep in, position sizes get tiny, trading costs soar, admin is a nightmare, research is endless, and you still might miss superstars. Performance hinges on your picking skills, which is risky.
Why Some Stick with Individual Stocks Over Funds
People avoid funds for reasons like costs, fund flows, and taxes—and those are fair. But you can sidestep them with low-cost passive ETFs or institutional funds, like Vanguard's MSCI Emerging Market ETF or DFA's International Small Cap Value Fund. They capture segments efficiently.
Then there are irrational fears from bad past experiences or comfort in big names like GE or Coke. Education is key here, but it takes time.
The Bottom Line
For proper diversification, allocate across asset styles and classes, not just industries, or you'll miss opportunities. Use ETFs and passive funds to cover the global market with just 12 securities—it's low-cost, tax-efficient, simple to manage, and just makes sense.
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