An oft-quoted statistic is that you only need about 20 stocks to make a well-diversified portfolio. Here I attempt to quantify the benefit of diversification. The result is that losses due to portfolio concentration are still quite high at only 20 stocks.
Meir Statman wrote a useful paper called How Many Stocks Make a Diversified Portfolio? In it he gives a table showing portfolio volatility values for varying number of stocks in the portfolio. The data is based on the portfolio having equally-weighted stocks.
From this table we can simulate a 30-year portfolio to see how much more volatility drag there is on returns for concentrated portfolios. I assumed that an investor would start with a lump sum and invest for 30 years. I set the starting lump sum so that a portfolio owning all stocks would finish at $1 million. The following chart shows how smaller numbers of stocks fared.
I call the difference between a portfolio of all stocks and a more concentrated portfolio the portfolio “concentration gap.” We see from the chart that the gap at 20 stocks is about $140,000, which I’d call quite significant.
So, why do so many people think that 20 of fewer stocks make sense? The answer is that they believe they can pick winning stocks. All of the above analysis is based on a random selection of stocks. If you can choose above-average stocks, then you can overcome the concentration gap. Of course, the vast majority of investors (but not quite all) who believe they are great stock-pickers are actually deluded.
The main takeaway from this article is that it isn’t good enough to have some stock-picking skill. You need enough skill to jump the concentration gap. If you have the talent and energy to find 20 above-average stocks, you need to be able to overcome the concentration gap and any other costs you incur that index investors would not incur.