One key watchword in the investment world is “diversification.” I suspect that a large majority of investors would probably agree as to the importance of this approach for managing investment risk as well as the risk of running out of money in retirement. In our firm’s case, we diversify not just across different asset classes, but also within each one. Our clients are invested in all 3,500 U.S. stocks and in more than 13,000 stocks globally.
But have you ever wondered what is the minimum number of stocks you’d need to hold to be sufficiently diversified?
I wrote in 2017 that Hendrik Bessembinder of Arizona State University discovered that the entire gain in the U.S. stock market since 1926 was attributable to just the best-performing 4% of listed stocks. If we assume that same percentage of stocks provides all the gains in any given year, all we’d need to do is invest in those 140 U.S. stocks not only to be well diversified, but also to ensure that we get the greatest possible return from the stock market. Right?
Not so fast. Which 140 stocks would you choose? You see, it’s not the same 140 stocks that capture all the gains from one year to the next. And if only 140 stocks experienced gains last year, then more than 3,300 didn’t. Which means a majority incurred losses. If you pick just 140 stocks to represent the broad market, you have only a 4% chance of holding the right ones.
What if you chose 280 stocks instead? That would double your chances of a gain. But 8% is still probably not what you’d consider to be good odds.
You see where this is heading? The only way to ensure that you hold all 140 positive-returning stocks is to invest in the entire U.S. market of 3,500 publicly traded companies. Even investing in only 3,400 of them risks missing some of the winners.
There are certainly investors, mutual fund managers and even investment advisers who claim to be able to pick the winners from the losers. I have yet to come across anyone who has been able to do so consistently from year to year over a retirement lifetime, no matter what creative methodology they used. If you flip a coin 10 times, you might get 10 heads in a row. But that’s still just luck, not skill.
The good news is that there are dozens of mutual funds and exchange-traded funds that invest in entire asset classes such as U.S. stocks at an extremely low cost. It is very easy today to be 100% diversified in most major asset classes. You won’t beat the market by doing so. But then again, why would you want to?