Jim Cramer, the star of CNBC's Mad Money use to do a segment called "Am I Diversified?" in which viewers would call in, give Cramer their top five holdings and Cramer would let them know if they were well 澳洲幸运5官方开奖结果体彩网:diversified.

The idea of five stock diversification is quite low and mostly refuted by the "stock picking" community, which tends to believe the number of individual stocks needed to be diversified is actually closer to 30. While 30 is no doubt better than five, it just isn't good enough.

It has long been known that diversification can help reduce one's portfolio risk while also boosting returns. Just how many stocks are enough to achieve a properly diversified portfolio—maximum diversification—has been a subject of research and debate. Owning 30 stocks across a range of industry sectors has become a rule of thumb for achieving diversification. But how good is this rule of thumb? Read on to find out.

Where Does the Magical Number 30 Come From?

In 1970, Lawrence Fisher and James H. Lorie released "Some Studies of Variability of Returns on Investments In 澳洲幸运5官方开奖结果体彩网:Common Stocks" published in The Journal Of Business on the "reduction of return scattering" as a result of the number of stocks in a portfolio. They found that a randomly created portfolio of 32 stocks could reduce the 澳洲幸运5官方开奖结果体彩网:distribution by 95%, compared to a portfolio of the entire 澳洲幸运5官方开奖结果体彩网:New York Stock Exchange.

From this study came the mythical legend that "95% of the benefit of diversification is captured with a 30 stock portfolio." Of course, no self-respecting stock jock would tell people they create a random portfolio so the 澳洲幸运5官方开奖结果体彩网:investment managers adjusted this to "We pick the best 30 and achieve max diversification at the same time." In this statement, they are essentially saying, "we can capture the return of the market and capture the diversification to the market by picking the 30 best stocks," and th🍃ey often use something like Figure 1🦋 to prove their claims. Unfortunately, neither point is really true.

Figure 1: Total portfolio risk as a function of the number of stocks held (%)

The Reduction of Risk Is Not the Same As Incre൩asing Diversification

The Fisher and Lorie study was primarily focusing on the 'reduction of risk' by measuring 澳洲幸运5官方开奖结果体彩网:standard deviation. The study was not actually about any improvements in diversification. A more recent study by Surz & Price addressed the shortcomings of the Fisher and Lorie study by using proper diversification measurements. Specifically, they looked to 澳洲幸运5官方开奖结果体彩网:R-squared which measures diversification as the percent of variance which can be attributed to the market as well as 澳洲幸运5官方开奖结果体彩网:tracking error which measures the variance of 澳洲幸运5官方开奖结果体彩网:portfolio returns versus its 澳洲幸运5官方开奖结果体彩网:benchmark.

The results of their sಞtudy, Ta♏ble 1, clearly show that a portfolio of even 60 stocks captures only 0.86 or 86% of the diversification of the market in question.

It is important to remember that even this concept of being 90% diversified with only 60 stocks is only relative to the specific market in question, i.e. U.S. 澳洲幸运5官方开奖结果体彩网:large-capitalization compa🐲nies. Therefore when you are building your portfolio, you must remember to diversify against the entire global market.

As we concentrate on decreasing risk in the portfolio, we must also remember to consider 澳洲幸运5官方开奖结果体彩网:opportunity cost; specifically, the risk of missing out on the best performing 澳洲幸运5官方开奖结果体彩网:stock markets. Figure 2 illustrates the historical performance among different areas of investments for the year 2010 broken down by style, sizes, and domestic or foreign.

Figure 2: Opportunistic tilt and diversification

To be properly diversified in order to adequately capture the market's returns and reduce risk, you must capture the entire global market and its known dimensions of size and style as listed.
1. Domestic Growth Small Companies
2. Domestic Value Small Companies
3. Domestic Growth Large Companies
4. Domestic Value Large Companies
5. Foreign Growth Small Companies
6. Foreign Value Small Companies
7. Foreign Growth Large Companies
8. Foreign Value Large Companies
9. Emerging Market Companies

Additionally, you must capture the entire industry diversification within each of the ab🌄ov𒆙e markets.

1. Telecom Services
2. Utilities
3. Energy
4. Consumer Staples
5. Health Care
6. Materials
7. Information Technology
8. Financials
9. Consumer Discretionary
10. Industrials

Finally, you must be sure to own the next great overachievers. A study entitled The Capitalism Distribution, by Eric Crittenden and Cole Wilcox, of the 澳洲幸运5官方开奖结果体彩网:Russell 3000 during 1983-2006 illustrates just how difficult that is. B𒀰elow are some of the highlights of their study that present a 🌱visual representation of just how few of the individual stocks are actually going to be the winners you need to be picking.

Summary Findings by Crittenden and Wilcox

• 39% of stocks were unprofitable
• 18.5% of stocks lost at least 75% of their value
• 64% of stocks underperformed the Russell 3000
• 25% of stocks were responsible for all of the market's gains

Figure 3: 澳洲幸运5官方开奖结果体彩网:Total returns of individual stock vs. Russell 3000 (1983-2006)

You must ask yourself how realistic is it that you or your stock manager can identify the top performers before they perform? How unrealistic is it to pick a few stocks and for one of them to be the next Dell (DELL) or Microsoft (MSFT) at the early stages of their run? How realistic is it tha💜t you end up with one of the almost 40% of stocks which lost money or one of the 18.5% that lost 75% of their value?

What are the chances today that you have the undiscovered overachievers in your account? The global stock universe is huge. Ask yourself, how many stocks do you really need to capture any specific area such as the 澳洲幸运5官方开奖结果体彩网:energy sector or the 澳洲幸运5官方开奖结果体彩网:financial sector? What if you only picked one and it was the one that went bankrupt? I doubt five per area would beꦓ enough, but for argument's sake, we'll 🃏say five stocks are adequate per area to feel confident.

The Minimum Needed

Whꦫen you look at it like this, you need a minimum of five stocks in over 200 industries, which equals 🧜over 1,000 stocks!

Realistic🐭ally I doubt even this number would be enough to capture the global equity portfolio. Some important things to consider before you start building a 1000 stock portfolio:

1. You would still have your or your manager's biases embedded into the portfolio.
2. Is your portfolio large enough to have a meaningful position size in each?
3. So many stocks to trade would increase the trading cost.
4. Administrative record-keeping and statements would be overwhelming.
5. Very difficult, time-consuming, and expensive to research and manage.
6. You still couldn't be 100% sure to capture every future super stock.
7. Performance dependent on your proprietary system or "s✤tock pickinꦏg guruness."

Why Do Some People Prefꦇer Individual Stocks🍌 to Funds?

ꦛThere are valid and rational concerns for not wanting to get into funds:

1. Cost
2. Fund Flows
3. Taxes

Fortunately, all of these concerns are easily overcome by only using low-cost, passive 澳洲幸运5官方开奖结果体彩网:institutional funds or 澳洲幸运5官方开奖结果体彩网:exchange-traded funds (ETFs). For example, Vanguard MSCI Emerging Market ETF (VWO) can tax-efficiently capture emerging 澳洲幸运5官方开奖结果体彩网:market segment well, while minimizing 澳洲幸运5官方开奖结果体彩网:fund flow issues and for a relatively low cost annually, but the fees could change. DFA International Small Cap Value Fund is a 澳洲幸运5官方开奖结果体彩网:mutual fund which attempts 🌸to capture the entire foreign value small company segment.

Though there🌼 are some valid concerns about funds, there is also a prevalence of invalid and irrational concerns:

• Bad experience due to poor fund selection, application, and timing
• Comfort in seeing familiar names such as General Electric (GE), Procter & Gamble (PG), Coke (KO), etc.

Unfortunately, little can be done to over꧋come these concerns besides education and patience.

The Bottom Line

A properly diversified portfolio should include a meaningful 澳洲幸运5官方开奖结果体彩网ಌ:allocatio♓n to multiple asset styles and classes. Not just industry diversification. Otherwise, you risk missing out on significant market opportunities. By using ETFs and institutional passive mutual funds, you can capture meaningful exposure to the entire global 澳洲幸运5官方开奖结果体彩网:market portfolio with as few as 12 sec💝urities and a relatively low total portfolio cost. It's tax-efficient, easy to understand, ☂monitor, manage and it makes good common sense.