How Many Stocks Are in the Ideal Portfolio?

For novice investors, one of the most frequently pondered questions is how many stocks they should own. But the truth is there’s no perfect answer.

As with anything else in investing, the ideal number of stocks for you depends on a number of factors, from your risk tolerance to your long-term goals to your overall investment strategy.

How much uncertainty can you handle? Are you saving up for retirement or are you looking to supplement your income? Are you a fundamentalist or do you prefer technical analysis? These are all questions that define your specific investor profile and shape your portfolio.

In other words, you have to figure out how many stocks are right for you.

Here are some of the most important factors to consider when determining your holdings.

Diversification

The entire question of how many stocks you own is rooted in diversification.

If you’re not familiar with this concept, diversification is to strategically spread one’s capital over a variety of stocks, with the goal of increasing its chances of success while reducing its overall risk profile.

Research shows that the more stocks your portfolio holds, the lower your company risk, while your market risk remains the same.

Market risks are systemic – they’re embedded into the larger machine of the economy (think of any major news event that impacts investor mentality – from a tropical storm to the elections).

Company risks (as you might be able to guess) are specific to a particular stock. They can take a number of forms: the company reports weaker-than-expected earnings…there’s a change in management…there’s a product recall‚ etc.

So when you own fewer stocks, your portfolio contains more company risk – in other words, there’s a greater likelihood that one company’s bed news could negatively impact your entire portfolio.

On the other hand, by owning more stocks, you can help blunt the impact of a single stock’s poor performance. Most experts agree that around 8-12 holdings is where you start to see a substantial decrease in your portfolio’s overall company risk. But once you own between 20-30 stocks, the decrease in company risk becomes minimal – in other words, there’s practically no additional advantage to holding 40 stocks than there is to holding 20.

According to Investment Analysis and Portfolio Management by Frank Reilly and Keith Brown, “If you own about 12-18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.”

Anything more than 18 starts to create an unmanageable portfolio.

Asset Allocation

When we talk about having an “equally weighted portfolio,” it means that each stock has the same capital allocation. So if you own 10 holdings, in an equally weighted portfolio, each would represent 10% of your total invested capital.

However, that doesn’t necessarily mean equal weighting is the way to go. This will ultimately depend on your own personal risk tolerance. For instance, the example above represents a riskier portfolio. If you had $10,000 invested, that means up to $1,000 (10%) could be impacted by any stock’s particular action – either for the positive or the negative.

A more conservative and commonly used approach, on the other hand, would be to allocate 2-3% of your overall portfolio to each position.

You’ll also want to consider how much time you’re willing to allocate to managing your portfolio. If you’re a more active trader and are willing to stomach greater risk for higher potential returns, for instance, you might allocate more of your holdings to some of your riskier (but more potentially rewarding) short-term trades. But in this case, you may want to hold more stocks to balance out some of the risk.

If you prefer a sit-back-and-watch approach, you may consider allocating more to positions that deliver healthy (if safer) returns over the long term.

Also, each sector and type of company comes with its own set of risks: small-cap growth names in the tech are riskier, but often lead to higher rewards. In this case, once again, you may want more holdings in your portfolio to counter some of the risk.

On the other hand, stable, large-cap dividend payers tend to be a safer bet, so you could hold fewer of these names without increasing your risk dramatically.

Quality over quantity

True diversification comes not from buying as many stocks as you can to meet some threshold…

It comes from owning quality stocks among a variety of sectors.

If your portfolio is too heavily concentrated in a single industry (say, biotech), then those sector risks present a significant problem to your portfolio.

One of the keys here is quality: As an investor, your mission should be to invest in the best companies. That means researching the names you intend to buy. It also means researching the names you already own, and selling positions that no longer meet your criteria.

The number of positions you own as any given time isn’t as important as owning good, solid companies that you believe will succeed. You also want to keep your goals in mind, whether that means collecting dividend income or buying into a risky trend. That will be an important factor in determining which stocks you want to hold.

The case for ETFs and mutual funds

If you’re not comfortable researching and investing in individual stocks, you might consider investing in mutual or exchange-traded funds instead. These funds offer automatic diversification without the need to manage individual holdings.

Magnifi makes this part easy, enabling investors to search for and identify promising investment options based on their own criteria.