Those less-in-the-know, or those who choose to know less, own mutual funds. One can construct various portfolios by changing the capital allocation weights the stocks in the portfolio. Active 3 years, 7 months ago.

Of course, the more stocks you hold, the lower your chances of outperforming the market, but your portfolio is less risky.So the key question to ask yourself is: "Why do I invest in individual stocks at all? Instead of having a competitive insight, you begin to run the risk of missing things. You may miss something important in the 10-K, skip on investigating the firm's second competitor, and so on.When you lose your focus and move outside your circle of competence, you lose your competitive advantage as an investor.Instead of playing with weak opponents for big stakes, you begin to become the weak opponent.Interestingly, holding a concentrated portfolio is not as risky as one may think.Just holding two stocks instead of one eliminates 46% of your unsystematic risk.

For this reason, it's irrational to quickly move in and out of wide-moat stocks and incur capital gains taxes and transaction costs.Your results, after taxes and trading expenses, likely won't be any better and may be worse.That's why many of the great long-term investors display low turnover in their portfolios. At the same time, you also increase your risk.It is also important to note that if you own more than 18 stocks, you will have achieved almost full diversification, but now you will just have to keep track of more stocks in your portfolio for not much marginal benefit.While much of academia has focused on the risk of not being diversified enough, there's also a practical risk to being too diversified.When you own too many companies, it becomes nearly impossible to know your companies really well.

By "fairly concentrated," we mean 12 to 20 stocks.Most investors will discover only a few good ideas in any given year — maybe five or six, sometimes a few more.Investors who hold more than 20 stocks at a time are often buying shares of companies they don't know much about, and then diversifying away the risk by holding lots of different names.It's tough to stray very far from the average return when you hold that many stocks, unless you have wacky weightings like 10% of your portfolio in one stock and 2% in each of the other 45.While many stock investors question many aspects of Modern Portfolio Theory, they do believe it contains some important frameworks that may help you to feel comfortable when investing in a concentrated portfolio.Academics have proved that of your total risk, you can diversify away your unsystematic risk.The larger the number of stocks you own, the more diversified you are, and the less unsystematic risk that you incur.For instance, if the profits of one of your companies are falling below expectations, and if you hold a large number of stocks, chances are another company in your portfolio is exceeding expectations.There is some risk that you can't diversify away the systematic risk.You cannot eliminate the risk from the macroeconomic factors that affect all stocks.
But why?The more stocks you hold, the lower your chances of underperforming the market. So even if you own 1,000 stocks, you will not diversify away the inherent risk of owning stocks.Once you own a certain number of stocks, you have eliminated all the unsystematic risk.When you have reached this point, there is no need to own any more stocks to diversify your risk of concentration, that is, the unique risks associated with any one stock.So how many stocks do you need to own to reach that point?In other words, if you own about 12 to 18 stocks, you have obtained more than 90% of the benefits of diversification, assuming you own an equally weighted portfolio.Essentially, the theory says that if you are properly diversified, on average, you will get the same return in the market as if you had bought a passive market index. Is this a correct way of calculating a value- and equally weighted portfolio?Thanks for contributing an answer to Quantitative Finance Stack Exchange! Learn more about hiring developers or posting ads with us Portfolio Risk. Essentially, the theory says that if you are properly diversified, on average, you will get the same return in the market as if you had bought a passive market index.


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