Stick to Your Strategy Stock Market Analogy for the Short Run and the Long Run

Stock Diversification and the Modern Portfolio Theory

According to the modern portfolio theory, you'd come very close to achieving optimal diversity after adding about the 20th stock. In Edwin J. Elton and Martin J. Gruber's book "Modern Portfolio Theory and Investment Analysis", they conclude that the average standard deviation (risk) of a portfolio of one stock was 49.2%, while increasing the number of stocks in the average well-balanced portfolio could reduce the portfolio's standard deviation to a maximum of 19.2% (this number represents market risk). However, they also found that with a portfolio of 20 stocks the risk was reduced to about 20%. Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio's risk by about 0.8%, while the first 20 stocks reduced the portfolio's risk by 29.2% (49.2%-20%). Many investors have the misguided view that risk is proportionately reduced with each additional stock in a portfolio, when in fact this couldn't be farther from the truth. There is strong evidence that you can only reduce your risk to a certain point at which there is no further benefit from diversification.