Diversification ...How much is needed

Diversification ...How much is needed Diversification is one of the fundamental principles of investing. It helps reduce the overall portfolio risk as you spread your investments across different avenues and asset classes.

Any risk that one takes in investments needs to be compensated by commensurate returns. By investing in very few stocks you run the risk of having very high risk, something that you do not usually get compensated for. Similarly, investing into too many stocks increases the cost of management and decreases the character of the portfolio without any real reduction in the risk.

So what is the optimal number of stocks that one should hold in a portfolio to call it adequately diversified?

Our analysis reveals that holding 13 to 22 stocks in a portfolio offers optimal diversification. Beyond 22 stocks, the marginal diversification benefit starts to decline significantly. On average, a well-diversified portfolio is found to contain 13 to 22 randomly chosen stocks. Risk reduction rate slows as you increase the number of stocks

The steepest drop in risk reduction takes place before 7-8 stocks. With the addition of 20th - 22nd stock, the curve flattens thereafter showing a slower rate of reduction in risk (variance) as the number of stocks is increased.

If you hold a portfolio of too many stocks, now may be the good time to cut through the clutter. Similarly, if you are holding too few, do increase the number of stocks.

While our study was done on random picks, a good diversification needs to be done scientifically so that risk-return trade-off is optimal. Happy Investing Source:Icicidirect.com