General   |   Oct 15, 2020

Conviction Versus Quantity

Diversification is an established concept from which several fields – from agriculture to sociology – have benefitted, and finance is chief among them. Modern Portfolio Theory (MPT) has illustrated that combining multiple holdings in a portfolio lowers its risk without necessarily sacrificing its return. Such diversification benefits are evident in equity investment, and over the decades, empirical research has found that investors can actually capture most of the diversification benefits with approximately 30 randomly-selected portfolio holdings.¹

Nevertheless, there remain fears of being too diversified or too concentrated, and the financial community is still divided about the “ideal” number of stocks to hold in a portfolio to achieve diversification and an optimal risk/reward balance. While we’d agree that investors shouldn’t put all their eggs in one basket, we also question whether the debate surrounding the ideal number of stocks is asking the wrong question entirely. More specifically, we posit that while portfolio diversification is key to investing success, the more pertinent factor driving this diversification isn’t the quantity of stocks, but rather, a portfolio manager’s conviction in the names they hold.

The law of diminishing marginal returns

Financial markets are unpredictable, and it’s common for investors and portfolio managers to believe that in their equity portfolios, a large number of holdings is crucial to reduce risk. But is this really the case?

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1 For example, see Statman, Meir. “How Many Stocks Make a Diversified Portfolio?” The Journal of Financial and Quantitative Analysis, vol. 22, no. 3, 1987, pp. 353–363.