Diversification vs. Concentration: How Many Stocks Should You Own?

Introduction

Diversification vs. concentration asks whether it’s better to own a broad basket of stocks or focus on a few companies you know well. This trade-off affects risk, potential returns, and how much time you need to manage a portfolio.

This article explains the difference between unsystematic risk and market risk, shows how many stocks typically capture most diversification benefits, and lays out practical steps for building a portfolio that fits your goals. You’ll get concrete examples using well-known tickers and clear, actionable rules to follow.

• Holding a diversified basket reduces company-specific (unsystematic) risk; the rest is market (systematic) risk.
• Research suggests 20, 30 well-selected stocks capture most diversification benefits; fewer than 10 leaves you exposed to idiosyncratic risk.
• Concentrated portfolios can outperform but require superior research, risk controls, and emotional discipline.
• Use low-cost broad ETFs like $VTI or $VOO for instant diversification if you prefer a hands-off approach.
• Blend diversification and concentration: a core holding of broad funds plus a satellite of 5, 10 conviction stocks is a practical strategy.

Why Diversification Matters

Diversification is the practice of holding multiple investments so that the poor performance of some doesn't sink the whole portfolio. It targets unsystematic risk, the company-specific events such as product failures, management scandals, or regulatory hits.

Unsystematic risk can be reduced through diversification because those negative events are often independent across companies. However, market risk, driven by interest rates, recessions, or global shocks, cannot be diversified away and affects almost all stocks at once.

Key concepts explained

• Systematic (market) risk: Risk that affects the whole market. Diversification can't remove this.
• Unsystematic (idiosyncratic) risk: Company-specific risk. Diversification reduces this.
• Correlation: How closely assets move together. Lower correlation between holdings increases diversification benefits.

How Many Stocks Capture Diversification Benefits?

Academics and practitioners have studied how many stocks are needed to meaningfully reduce unsystematic risk. A commonly cited rule is that holding 20, 30 stocks across different industries captures most of the reduction in volatility from diversification.

For example, early studies showed that the largest drop in portfolio variance happens as you go from 1 to 10 stocks. Additional variance reduction continues up to about 20, 30 stocks, after which the marginal benefits taper off.

Numbers to keep in mind

• 1, 5 stocks: Very concentrated. Performance driven mostly by individual company outcomes; volatility is high.
• 10, 15 stocks: Substantial reduction in unsystematic risk, but some company risk remains.
• 20, 30 stocks: Most unsystematic risk is diversified away for many portfolios.
• 50+ stocks: Extra diversification gains are small for typical retail portfolios unless stocks are highly correlated.

Real-World Examples: Diversified vs. Concentrated

Concrete examples help make the trade-offs tangible. Imagine two hypothetical portfolios started five years ago with equal dollar positions in each holding.

Example A, Focused 6-stock portfolio

Holdings: $AAPL, $MSFT, $AMZN, $TSLA, $NVDA, $JPM. These are large, well-known companies with strong recent returns. If most holdings perform well, the concentrated portfolio can outperform a broad index. But one major negative event at a single holding (for example, a large drawdown at $TSLA or $NVDA) can significantly reduce overall returns.

Example B, 30-stock diversified portfolio

Holdings: 30 mid- and large-cap stocks across sectors (technology, healthcare, consumer staples, financials, industrials). This portfolio likely shows smoother returns and lower single-year drawdowns. It will usually track closer to the broad market like $VTI but with some idiosyncratic tilt depending on stock choices.

Practical takeaway: A concentrated portfolio magnifies both upside and downside from individual stock outcomes. A diversified portfolio smooths returns but may dilute extreme outperformance.

Benefits of Concentration

Concentration can be attractive for investors who have an informational edge, deep research, or high conviction in a few businesses. Historically, concentrated bets have led to outsized returns for some investors, Warren Buffett is a commonly cited example, though his approach includes large holdings in a few high-conviction businesses plus conservative cash management.

Concentration benefits include higher potential returns, lower transaction costs, and easier monitoring when you deeply understand each company. But those benefits come with higher tail risk: one bad outcome can be ruinous for a small portfolio.

When concentration may make sense

• You have time and skills to research businesses in depth.
• You understand and can tolerate higher volatility and drawdowns.
• Your holdings are in businesses with low correlation to each other to mitigate some risk.

Constructing a Portfolio: Practical Steps

Most beginners benefit from a simple, repeatable approach: build a diversified core, then add a limited number of concentrated positions if desired. This “core-satellite” model balances diversification and conviction.

1. Decide your core: Choose a broad equity ETF like $VTI (total US stock market) or $VOO (S&P 500) for immediate, low-cost diversification.
2. Set a satellite budget: Allocate a modest percentage (5, 20%) of your investable assets for individual stock positions where you have conviction.
3. Limit the satellite count: If you choose individual stocks, 5, 10 conviction holdings is a manageable range for most retail investors.
4. Position sizing and risk controls: Avoid letting any single stock exceed a predefined percentage (e.g., 3, 5% of the total portfolio) unless you accept the extra risk.
5. Rebalance periodically: Rebalance annually or semi-annually to maintain your target allocations and lock in gains or limit concentration drift.

Example allocation

A straightforward starting allocation might be 80% in a broad ETF like $VTI and 20% in five individual stocks ($AAPL, $MSFT, $AMZN, $JNJ, $DIS), each sized at 4% of the total portfolio. This offers market exposure while allowing meaningful positions in companies you research.

Measuring and Managing Risk

Two practical metrics help monitor diversification: concentration by weight and correlation among holdings. High concentration means a few holdings make up a large share of portfolio value. High average correlation means holdings tend to move together, reducing diversification benefits.

Tools: Many broker platforms show top-holding percentages and sector exposures. You can also calculate simple statistics like portfolio standard deviation or use free portfolio checkers to estimate historical volatility and drawdowns.

Stress testing

• Scenario analysis: Ask what happens if major holdings drop 30% in a bear market.
• Sector stress: Check exposure to a single sector (e.g., tech) that might decline sharply.
• Liquidity check: Ensure you can exit positions without excessive slippage if needed.

Tax and Cost Considerations

Concentrated trading tends to generate more transactions, which can increase fees and short-term capital gains taxes. Holding a diversified ETF often minimizes trading and is tax-efficient, especially in tax-advantaged accounts.

For taxable investors, consider realizing gains strategically and using tax-loss harvesting to offset gains. Always factor in commissions, bid-ask spreads, and potential market impact when trading larger individual positions.

Common Mistakes to Avoid

• Too few stocks without expertise: Holding 3, 5 stocks without deep knowledge leaves you exposed to idiosyncratic risk. How to avoid: Increase the number of holdings or switch to ETFs if you lack time for research.
• Poor position sizing: Letting one stock become >10% of your portfolio because it’s doing well. How to avoid: Set and enforce position-size limits and rebalance periodically.
• Overconfidence in picks: Believing you can consistently pick winners without a process. How to avoid: Use checklists, objective research, and consider blending with passive strategies.
• Neglecting correlation: Owning many stocks in the same industry thinking you’re diversified. How to avoid: Check sector and correlation exposures and diversify across industries.
• Ignoring costs and taxes: Frequent trading increases expenses and tax bills. How to avoid: Use tax-advantaged accounts and limit turnover.

FAQ

Q: How many stocks does the average diversified mutual fund or ETF hold?

A: Many broad mutual funds and ETFs hold hundreds or thousands of stocks. For example, $VTI (Vanguard Total Stock Market) holds thousands of U.S. stocks, delivering immediate, high-level diversification across market caps and sectors.

Q: If I only have a small amount to invest, is concentration OK?

A: If you have limited capital, concentration is common because buying many individual stocks can be costly. In that case, using a low-cost broad ETF for core exposure and adding one or two individual stocks is a sensible approach.

Q: Will diversification reduce my returns?

A: Diversification tends to reduce extreme outcomes, both big losses and big gains. Over time, it typically reduces volatility without necessarily lowering the long-term average return compared with taking unnecessary company-specific risks.

Q: Can diversification protect me in a market crash?

A: Diversification reduces company-specific losses but cannot eliminate market-wide declines. In a broad market crash, most equities fall together, so diversification alone won't prevent losses tied to the overall market.

Bottom Line

The decision between diversification and concentration depends on your skills, time, risk tolerance, and goals. For most beginners, a diversified core using a broad ETF plus a small set of conviction stocks offers a balanced, practical approach.

Key actions: decide on a core allocation, limit the size and number of concentrated positions, monitor sector and correlation exposures, and rebalance periodically. These steps will help you capture diversification benefits while allowing upside from a few well-researched ideas.

Keep learning and refine your approach as experience grows. Whether you favor diversification, concentration, or a mix, the most important asset is a clear plan you can stick with through different market environments.