by Krystal Daibes Higgins, CFA
Senior Vice President
Equity Research and Portfolio Management
Investors commonly believe that a greater number of holdings automatically increases diversification. After all, many have heard the adage, “Don’t put all your eggs in one basket.” While intuitive, this view confuses the number of securities in a portfolio with actual risk control. As investment managers that serve nonprofits and other institutional clients, we sometimes address this belief during investment committee meetings.
Stocks
For domestic large-cap equity portfolios, empirical evidence suggests that most idiosyncratic or nonsystemic equity risk is diversified away with as few as 30 stocks, assuming reasonable sector and industry breadth. Ferguson Wellman’s domestic large-cap portfolios, which comprises approximately 40 companies, have produced a lower volatility metric than that of the S&P 500 in most periods while largely keeping pace with index returns. By increasing the number of securities beyond 40 companies, incremental reductions in portfolio volatility are modest and eventually level off. It is important to recognize that simply increasing the number of portfolio holdings does not inherently reduce volatility. Position size must be determined by the portfolio’s specific investment strategy and not by arbitrary thresholds.
The relationship between portfolio size and risk reduction is nonlinear. The first several stocks meaningfully reduce company-specific volatility. A single stock bears full exposure to both company-specific and market risk and by the time a portfolio reaches 10 stocks, a substantial portion of company-specific risk has been diversified away. Once a portfolio reaches 30 stocks, most remaining idiosyncratic risk is mitigated, provided the holdings are not economically redundant. After that point, portfolio volatility is predominantly driven by systematic factors such as market beta, interest rates, inflation sensitivity and style exposures. In other words, adding more companies does little to change how the portfolio behaves in a broad market drawdown: it will largely move with the market.
Source: Markowitz, Harry, “Portfolio Selection.” The Journal of Finance, vol. 7, no. 1, 1952, pp 77-91
Asset Allocation
This framework becomes even clearer within a balanced portfolio. A typical allocation of 60% to equities and 40% to high-quality bonds already provides an additional layer of diversification. Bond duration, which is a portfolio’s sensitivity to interest rates, and income stability help offset equity volatility. The correlation between high-quality bonds and equities has historically been meaningfully low. As a result, total portfolio volatility is driven by how one asset interacts with another asset, not simply by the number of stocks in the equity portfolio. Expanding the number of stocks beyond the point of diminishing returns often has far less impact than maintaining appropriate asset allocation discipline.
Multiple Managers and Funds
Before an institution chooses multiple managers or funds, it should first consider their objectives. Using multiple funds with similar strategies can add little diversification, especially if holdings overlap. Overlaps, common in large-cap equities, may concentrate risk despite a higher number of stocks. Because managers act independently, aggregate sector exposures, factor tilts and total portfolio risk can lead to a collection of diversified funds rather than a deliberately constructed portfolio.
Effective diversification is achieved through thoughtful portfolio construction and coordination of risks, not simply by increasing the number of holdings.
Conversation Starters for Nonprofit Professionals and Board Members
How many stocks are typically sufficient for diversification?
Most research indicates that holding at least 30 diversified stocks eliminates the majority of company-specific risks. The precise number depends on sector breadth and correlation among holdings.
Should investors utilize multiple investment managers or mutual funds?
It depends. Using multiple funds with similar strategies offers few diversification benefits. Overlapping holdings or similar factor exposures limit diversification, even if the number of stocks is high.
Why does the diversification benefit flatten out?
Once company-specific risk is largely diversified away, systematic market factors become the dominant drivers of volatility. Additional stocks do little to change exposure to those broad forces.
How does a balanced portfolio affect this analysis?
Owning high-quality fixed income securities largely reduces total portfolio volatility and provides diversification across asset classes. This cross-asset interaction often matters more than expanding the number of equity holdings beyond the point of diminishing returns.
Disclosure: The views expressed represent the opinion of Ferguson Wellman. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Statements of future expectations, estimates, projections and other forward-looking statements are based on available information and Ferguson Wellman’s views as of the time of these statements. Past performance may not be indicative of future results. Ferguson Wellman, Octavia Group and West Bearing do not provide tax, legal, insurance or medical advice. This material has been prepared for general educational purposes only and not as a substitute for qualified counsel who can determine how this information applies to you. We believe the information provided is from reliable sources but should not be assumed accurate or complete.
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