Diversification Myths: Why More Stocks Isn't Always Better

Key Takeaways

• Diversification reduces unsystematic (company-specific) risk quickly; most benefits accrue in the first 20, 30 stocks.
• Over-diversification occurs when additional holdings add complexity, transaction costs, and governance friction without meaningful risk reduction.
• Correlation, concentration, and position sizing matter more than raw stock count for risk and return outcomes.
• Use core-satellite structures, ETFs, and limits on position count or turnover to avoid dilution of gains.
• Measure marginal benefit: evaluate how each additional position reduces portfolio volatility and expected tracking error.

Introduction

Diversification is the practice of spreading capital across multiple securities to reduce risk. The popular belief that "more stocks equals safer portfolio" is rooted in modern portfolio theory, which shows that combining assets lowers unsystematic risk.

But that idea has a practical limit: past a certain number of positions, each additional stock reduces risk by smaller amounts and can start to dilute returns. For intermediate investors, understanding where that point lies and why it matters helps design efficient, actionable portfolios.

This article explains the mechanics behind diminishing returns from adding stocks, shows how correlation and concentration drive outcomes, and provides practical guidance and examples for managing position count without sacrificing diversification.

The Theory: Why Diversification Works, and When It Stops Helping

Diversification separates total portfolio risk into systematic risk (market-wide) and unsystematic risk (company-specific). Systematic risk cannot be diversified away; unsystematic risk declines as you add independent positions.

Mathematically, portfolio variance is driven by variances of holdings and their covariances. If you own perfectly uncorrelated stocks, variance falls quickly as you add positions. In the real world, correlations are positive, so risk reduction follows a curve of diminishing returns.

Key drivers

• Correlation: Higher average correlation between stocks slows diversification benefits.
• Number of positions: Marginal reduction in unsystematic risk decreases after ~20, 30 stocks.
• Concentration and sizing: Unequal weights or large single positions reintroduce company risk.

Empirical Evidence: Where the Curve Flattens

Academic and practitioner studies often find that a well-diversified portfolio captures most unsystematic risk reduction by the time you hold 20, 30 stocks. For U.S. large-cap equities, the marginal volatility reduction after 30 names is small relative to the complexity cost of more positions.

Real-world tests using historical returns show that: portfolio standard deviation drops quickly up to ~20 holdings, continues to drop but more slowly up to ~50, and flattens thereafter. The exact knee-point depends on correlation structure and sector concentration.

Quantifying marginal benefit

1. Start with an equal-weight sample of N stocks; compute portfolio volatility.
2. Add one new uncorrelated stock and recompute volatility; the reduction is the marginal benefit.
3. Repeat until marginal benefit approaches zero or is smaller than costs (fees, time, taxes).

Over-Diversification: Costs and Hidden Risks

Over-diversification (also called diagonalization or the "diworsification" effect) happens when adding assets reduces the potential upside and increases operational costs, without materially lowering risk. You can end up owning an index-like portfolio without the benefits of concentration where skill can add value.

Costs include higher transaction fees, increased tracking error to your intended strategy, attention and monitoring burden, and suboptimal position sizing that hides idiosyncratic conviction. Over-diversified retail portfolios often resemble a passive ETF but with higher taxes and trading costs.

Examples of hidden risks

• Performance dilution: Small stakes in high-conviction winners may not meaningfully contribute to gains.
• Execution friction: Managing 100+ positions raises time spent on rebalance, taxes, and record-keeping.
• Correlation breakdowns: During crises correlations spike, making a large number of stocks no safer than fewer holdings.

Practical Guidelines: How Many Stocks Should You Hold?

There is no one-size-fits-all answer. Optimal number depends on investor goals, time horizon, strategy (active vs passive), and ability to research and monitor positions. Still, practical rules help avoid over-diversification.

For most active, retail investors focusing on individual stock selection, a concentrated but diversified portfolio of 15, 40 holdings often balances risk reduction and upside capture. For passive investors, using broad-market ETFs like $VTI or $VOO can provide diversification without needing dozens of individual stocks.

Actionable setups

• Core-satellite: Hold a diversified ETF core (e.g., $VTI) and 5, 15 satellite individual names for alpha potential.
• Equal-weight tracking: If pursuing stock-picking, aim for 20, 30 equally weighted high-conviction positions to avoid single-name dominance.
• Position limits: Apply maximum position sizes (e.g., 5, 10%) and minimum meaningful sizes (e.g., >1%) to reduce mechanical noise from tiny holdings.

Real-World Examples

Below are illustrative scenarios showing how marginal benefits decline and how dilution can occur in practice.

Example 1, Rapid benefit early on

Imagine you build an equal-weight portfolio from a universe of 100 large-cap stocks. With 5 stocks, portfolio volatility might be 18%. Adding stocks reduces volatility as follows: 5 stocks = 18%, 15 stocks = 13%, 30 stocks = 11.5%, 60 stocks = 10.9%, 100 stocks = 10.7%.

The biggest drop occurs between 5 and 30 names. Moving from 30 to 100 stocks only lowers volatility by ~0.8 percentage points, while increasing trading and monitoring costs substantially.

Example 2, Concentration effect on returns

Consider a simulated investor holding 50 stocks equally weighted vs another holding 20 stocks equally weighted. If three holdings become big winners (e.g., $AAPL, $MSFT, $NVDA) generating 60% of the portfolio's alpha, the 20-stock investor has higher exposure to these winners per position and captures more upside, while the 50-stock investor's exposure is diluted.

This shows that when skill or insight is concentrated, a too-large portfolio can lower expected return for the same market risk.

Example 3, Crisis correlation spike

During market crises correlations across equities rise sharply. For example, in 2008 and early 2020, historically diversified equity buckets moved together. If correlations jump from 0.2 to 0.7, the practical diversification benefit of adding names vanishes, and owning 100 stocks provides little downside protection versus 20.

Thus, relying solely on position count fails to shield portfolios from systemic shocks.

How to Measure When You've Crossed the Line

Use concrete metrics to decide whether another stock is worthwhile. Focus on marginal volatility reduction, expected contribution to returns, and cost-benefit considerations.

• Marginal volatility reduction: Compute portfolio volatility before and after adding a position. If reduction is negligible, skip it.
• Expected information ratio: Is the new position expected to improve portfolio information ratio after fees and taxes?
• Operational cost: Factor in transaction costs, bid-ask spreads, and monitoring time.

Keeping a simple spreadsheet or using portfolio tools to model these numbers prevents emotion-driven accumulation of small, redundant positions.

Common Mistakes to Avoid

• Equating count with safety: Owning 100 names doesn’t automatically equal better diversification if holdings are correlated. Focus on correlation and sector exposure instead.
• Neglecting position sizing: Too many tiny positions create noise. Set minimum meaningful sizes and maximum concentration thresholds.
• Ignoring costs and taxes: Frequent trades to add small positions can erode returns through commissions, spreads, and taxable events.
• Failing to measure marginal benefit: Adding positions without calculating expected volatility reduction or alpha contribution leads to diminishing returns.
• Copying checklists blindly: Mimicking large funds' holdings count, without matching resources or strategy, can create suboptimal outcomes.

FAQ

Q: How many stocks should a typical active retail investor hold?

A: A reasonable range is often 15, 40 holdings for active retail investors. That range balances diversification against the ability to research and meaningfully size positions. Use a core-satellite approach if you want broader exposure with fewer individual names.

Q: Do ETFs eliminate the need to own many individual stocks?

A: Yes, broad-market ETFs like $VTI or $VOO provide instant diversification across hundreds or thousands of stocks, reducing the need to own many individual names unless you are pursuing active alpha with conviction.

Q: Can I diversify by owning companies across different sectors?

A: Sector diversification helps but is not sufficient. You also need to consider correlation within sectors, geographic exposure, factor risks (value, growth), and style exposures to achieve meaningful diversification.

Q: How do I know if my portfolio is over-diversified?

A: Signs include many small positions that contribute little to risk or return, high turnover with minimal performance improvement, and the portfolio behaving like a passive index despite active selection. Quantify marginal volatility reduction and expected return contribution to confirm.

Bottom Line

Diversification is essential, but more stocks is not always better. Most unsystematic risk reduction happens in the first 20, 30 holdings; beyond that, additional positions often add complexity, costs, and dilution without meaningful risk mitigation.

Focus on correlation, position sizing, and the marginal benefit of each new position. Practical solutions include core-satellite structures, position limits, ETFs for broad exposure, and a disciplined process to measure whether a new holding improves portfolio efficiency.

Takeaways for next steps: audit your portfolio for tiny positions, compute marginal volatility reductions for proposed additions, and consider concentrating on high-conviction ideas while using diversified ETFs to cover broad market exposure.