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If you’re new to investing, you’ve probably heard of diversification — but building a truly diversified portfolio takes a lot of work.
Millions of investors jumped into the stock market during the pandemic, as meme stocks and cryptocurrency dominated Wall Street’s news cycle and FOMO took over. But if you opened an account on a trading platform like Robinhood just to buy an Apple stock here and a Starbucks stock there, chances are you’re not setting yourself up for success.
"Sometimes people buy stocks because they heard about them from friends or they’re bored and it turns into sort of like a hobby,” says Amy Arnott, a portfolio strategist at Morningstar. But when you own just a few stocks, you run the risk that one disaster could blow up your whole portfolio, she adds.
Evidence suggests many investors may be falling into that trap. The average Robinhood user only owned two different companies’ stocks or exchange-traded funds, according to a 2019 analysis of Robinhood account data. (Robinhood has since ceased publishing account data and declined to comment for this story.) Meanwhile Invstr, a commission-free brokerage that also offers financial education, says its investors on average have just four stocks in their accounts.
Avoid those mistakes. Here's what you need to know about building a truly diversified stock portfolio.
The benefits of diversification
When you invest, you could face two types of risk: market risk and firm-specific risk. Market risk is inevitable — the market will move and there’s a chance you’ll lose money. Firm-specific risk, however, refers to the uncertainty of a specific area of the market or even a specific stock, and diversification can help you lower that risk.
“Not every stock will be subject to the same factors or move in the same direction everyday,” Arnott says. “Usually by increasing the number of stocks, you can lower the portfolio’s risk profile to a certain extent.”
About 39% of all U.S. stocks have had 3-month losses of 50% or more, but less than 1% of all diversified U.S. equity funds have had losses that severe, according to data from Morningstar.
How many stocks you need to own to build a diversified portfolio
The stock market is anything but predictable, so it’s hard to determine exactly how many stocks will give you enough diversification to weather the storm of volatility. But experts have done their best to get a good estimate.
In 1970, academics Lawrence Fisher and James Lorie published their findings that a portfolio of around 30 stocks can provide enough diversification to limit risk while still raking in returns. And in the book “Investment Analysis and Portfolio Management,” Frank Reilly and Keith Brown wrote that owning about 12 to 18 stocks will give you more than 90% of the benefits of diversification.
The sweet spot may be somewhere in the middle.
Haran Segram, a clinical assistant professor of finance at the NYU’s Stern School of Business, says between 20 and 25 stocks are needed for a diversified portfolio. Anything above 25 will only offer marginal benefits, he adds.
At least 20 individual stocks is a good rule, and you want to make sure you never allocate more than 5% of your portfolio to any one stock, Arnott adds.
What stocks to buy for a diversified portfolio
It’s not just about how many stocks you have in your portfolio, but which stocks you have.
If somebody were to put 20 to 25 stocks in financial services only, for example, that is not diversification, Segram says. They need to make sure those stocks cover at least seven to eight sectors.
But picking individual stocks is a lot of work. Unless you’re an active investor who can successfully trade in and out of popular stocks — which is very hard to do — you’ll want to go for companies that have a long, healthy future. Determining that means digging through their financials, checking up on their revenue and cash flow and analyzing their underlying fundamentals.
“It takes more time, more commitment,” Segram says. “It cannot be a hobby or a part-time thing I do when I have 10 minutes.”
On top of diversification across different industries, investors also need to think about investing in companies of different sizes, and foreign companies as well as domestic. You also want to make sure not all the stocks in your portfolio have similar traits. For example, if you only have meme stocks in your portfolio, they may move as a group.
If you own specific stocks but don't cover all the bases of a well-diversified portfolio, you can fill in the gaps with funds.
Say you have a portfolio with large-cap stocks, like Microsoft and Facebook. You can round out your holdings with a small cap index fund, an international index fund or alternative investments like real estate investment trusts (REITs), says Leon LaBrecque, chief growth officer and financial advisor at Sequoia Financial Group. (Index funds track a specific group of securities, like the S&P 500.)
You can also cover more sectors this way. If you own bank stocks like Bank of America, for example, you could add sector ETFs to your portfolio, like energy or health care funds. Consider the Select Sector SPDR ETFs, index funds for each of the S&P 500's 11 sectors.
"A well-diversified portfolio is the best way to get returns and reduce risk," LaBrecque says.