Everyone “knows” you should have a diversified portfolio. What other kind of portfolio would you want? Yet most people don’t really know what diversified means. What does a diversified portfolio look like? How many stocks do you need to own to achieve true diversification? The short answer: All of them.
The long answer is a little more nuanced, but comes to basically the same place: all of them, with a little bit of wiggle room. If you’re just looking to reduce your standard deviation, you only need somewhere between 30 and 50 stocks to knock most of the variance down. But that’s not diversification.
Let’s look at what “diversified” actually means. A truly diversified portfolio represents the mixed landscape of the stock market, and there are way more than 50 stocks out there. The real value of diversification is not simply smoothing out some of the ups and downs (though that is pretty valuable). The true value lies in building your portfolio around the things that actually matter — the systematic risks that you are compensated for taking.
Academics, by and large, break risk into two categories — systematic and unsystematic. Or, more directly, compensated and uncompensated risks, respectively. The basic idea is that the market “pays” you for systematic risks that you can’t get rid of, like stocks being riskier than bonds. But you don’t get paid for unsystematic risks that you can get rid of, such as a company’s CEO getting hit by a bus. Those types of risk are just noise, and they cancel out over time. We want to focus on the systematic (compensated) risk, and get rid of the unsystematic risk, which, to put it simply, we can diversify away. I know, it’s confusing. Don’t worry, we’ll cover systematic and unsystematic risk in more detail in my next post.
Once we’re left with systematic risk, we can target the amount and types of risk we want to take. Actually eliminating unsystematic risk requires bringing in a huge number of stocks — significantly more than simply smoothing out the day-to-day gyrations. If you only own the 30 to 50 stocks needed to dampen the daily bounces, you’re still exposed to only a very small portion of the market. To give you a sense of perspective, as of the end of April 2015, there were 3,637 publically traded stocks in the US. If you want to capture the economic experience of the US stock market, then you need to own something close to all 3,637 stocks, and if you are looking for exposure to the global economy, we’re talking about a whole lot more. As of April 2015, there were 12,333 publically traded stocks throughout the global market. You don’t need to own every company, but the closer you come (and you can come pretty close) the better. It may sound expensive to accomplish, but with mutual funds or ETFs, it’s actually pretty easy. Most mutual fund families, such as Dimensional Fund Advisors, or Vanguard, will be able to provide decent global stock exposure.
Every company is unique in their specifics. They are all going to succeed or fail in their own way, but in aggregate, they make up the work economy. And to represent that economy, you need to own enough stocks to cancel out the specifics.
Diversification is for more than just smoothing out your investment returns. It does that for you, but it goes much further. Diversification gets the noise out of the way so you can focus your investments on the risks that you actually want to take.