Diversification isn't about how many stocks you own—it's about which ones

Mint

15-05-2025

Scrolling through X last week, I stumbled upon a yellowed clipping from a 1996 issue of the ABA Journal titled 'Spreading the Wealth.' It was a throwback to a slower era—long before robo-advisors and trading apps. It got me thinking: how far have we really come in our understanding of diversification?
The article, written by Jon Newberry, explained the mathematics of diversification with a clarity that's often missing in today's personal finance conversations. Despite all the advances in investing—smartphones, AI trading, and global markets—the core principles of sound investing haven't changed much since 1996. That old article was a timely reminder for me to revisit a topic I've often written about: the true role of diversification in an investment portfolio.
I frequently hear from readers who proudly describe their portfolios as 'well-diversified." But when I look closer, many of these are simply long lists of holdings—dozens of individual stocks or mutual funds—that give the appearance of safety while creating new problems.
One striking example: an investor held over 40 stocks, but the top five accounted for more than 60% of the portfolio's total value. The remaining 35? Too small to make a real difference, but still adding complexity, paperwork, and stress.
Also read: Devina Mehra: Diversified or concentrated portfolio? It's an easy choice
This brings us to a fundamental question that too few investors ask themselves: What exactly is diversification meant to achieve?
The basic premise, of course, is protection against catastrophic loss. As investment legend Philip Fisher pointed out back in 1958 (and as cited in that ABA Journal piece), having "too many eggs in so many baskets" can mean that many eggs don't end up in attractive baskets. Diversification isn't simply about quantity; it's about intelligent risk management.
The math of risk
One of the most striking points from the article was a simple mathematical illustration. If a portfolio holds just one security, there's a 33% chance—based on their example—that the entire investment could be wiped out. Add a second, uncorrelated security, and the risk drops significantly. With three uncorrelated holdings, the chance of losing everything falls to just 4%. By the time you have five well-selected securities, the risk of total loss drops below 0.5%. The exact figures may not hold in today's market, but the principle behind them remains powerful.
However, this is where many investors misunderstand diversification. They assume that more is always better. In reality, diversification comes with diminishing returns. The leap from one to five stocks delivers a big reduction in risk. But the difference between holding 20 and 50? Minimal at best. Meanwhile, the costs—more time, more paperwork, more mental clutter—keep piling up with each new addition.
Also read: When math mistakes cost more than money
Real diversification isn't just about quantity but quality— spreading investments across assets that respond differently to various economic conditions. This means diversifying across company sizes (large, mid, and small-cap), sectors, geographies, and even asset classes (equities, fixed income, perhaps some commodities). A truly diversified portfolio might contain fewer individual securities than you'd expect, but they're carefully selected to complement each other.
Keep it simple
A handful of well-chosen mutual funds can provide all the diversification needed for the average investor. A large-cap fund, a mid/small-cap fund, and an international fund cover most bases on the equity side. Add a debt fund for fixed income exposure, and you have a robust portfolio with just four holdings. Each fund already contains dozens of securities selected by professional managers, giving you the benefits of diversification without the administrative headache.
Also read: Why is asset class diversification more crucial now than ever?
The article mentions that the legendary Peter Lynch, who ran the Fidelity Magellan Fund, sometimes owned over 1,000 stocks. What it doesn't mention is that Lynch managed billions of dollars and had a team of analysts helping him track these investments. For the ordinary investor, attempting to replicate this approach is not just unnecessary—it's counterproductive.
Excessive diversification also has a significant psychological cost. When your portfolio contains dozens of holdings, staying properly informed about each one becomes virtually impossible. This often leads to passive neglect of large portions of your investments—precisely the opposite of the engaged, thoughtful approach that successful investing requires.
I advocate a middle path when it comes to diversification—not too little, not too much, but just enough. For most investors, that sweet spot lies somewhere between five and ten well-chosen investment vehicles. The goal is to balance risk protection with practicality—enough diversification to guard against major losses, but still manageable enough to track and evaluate properly.
Also read: PMS vs mutual funds: How have portfolio managers fared on returns?
It's also important to remember that diversification is no substitute for due diligence. A portfolio filled with low-quality or overlapping investments—even if large in number—won't outperform a smaller collection of carefully selected, high-quality assets. When it comes to investing, quality always trumps quantity.
Ultimately, effective diversification isn't about scattering your money as widely as possible. It's about placing it wisely. After a point, adding more investments doesn't increase your safety—it just increases your workload. And, as in many areas of life, when it comes to building a smart portfolio, simplicity often beats complexity.
Dhirendra Kumar is the founder and CEO of Value Research, an independent investment research firm