Diversified? How Many Stocks

Just how many stocks does it take to be diversified? Some un-named popular TV shows would have you believe it only takes 5 stocks to be diversified. Nothing could be further from the truth. Imagine for a moment that you only had five stocks in your total portfolio. What happens if one of those stocks went bankrupt? You would lose 20% of your portfolio because you failed to be diversified. Don’t think this could ever happen to you? Somehow I bet the owners of Enron, WorldCom, and most recently Bear Stearns said the same thing.

The true danger in owning only a few stocks does not come from the off chance that a blue chip company goes under. The real danger is that you do not pick the correct stocks and in the long term you under-perform the market. This is actually more likely than it seems. The number of stocks you hold in a portfolio has a lot to do with how close you are to market returns. As an investor increases the number of stocks in a portfolio he is an actuality getting closer and closer to the market average. If an investor only holds a small number of stocks then they increase the chance of either completely underperforming or outperforming the index by a large margin.

So how many stocks does it take to be diversified? In order to be completely diversified you should simply own an index. An index holds every stock in the market and as such you can not be more diversified. If you insist on only holding a few stocks then sure you might outperform the market; at least for awhile. Eventually random chance will catch up with you and your portfolio returns will be a complete disaster.