How Many Stocks Should You Hold in Your Portfolio?
When building a stock portfolio, one of the most important questions to answer is: How many stocks should you hold to effectively diversify and reduce risk? Conventional wisdom suggests that holding around 15–20 stocks can provide sufficient diversification, but recent research and data studies the ideal number of stocks in general and across specific universes. Let’s take a closer look at the findings to understand the ideal portfolio size.
Methodological considerations of the study
1. Portfolio Construction: For each universe, 16 portfolios are created, varying in the number of holdings from 5 to 80 stocks in increments of 5. This approach results in 96 unique portfolios examined each month.
2. Momentum Calculation: The study uses the standard academic construction of momentum, calculated as the total returns over the past 12 months, excluding the most recent month.
3. Rebalancing: Portfolios have been rebalanced monthly
4. Time Period: The study covers the period from October 2004 to April 2023, providing a substantial dataset spanning various market conditions.
5. Performance Metrics: Key metrics examined include annualized returns, standard deviation, Sharpe ratio, and maximum drawdown characteristics
Key Insights
Mean Annual Return Declines as Portfolio Size Increases:
— As you increase the number of stocks in the portfolio (from 5 to 80 stocks), the mean annual return tends to decrease slightly. For example, a 5-stock portfolio yields 35.37%, while an 80-stock portfolio yields 28.55%.
— This indicates that diversifying more reduces the potential for extremely high returns, but may offer other advantages like risk reduction.
Risk Decreases with Larger Portfolios:
— The annual standard deviation, a measure of volatility (or risk), also declines as the number of stocks increases. The 5-stock portfolio has a standard deviation of 36.04%, while the 80-stock portfolio reduces this to 27.22%.
— This supports the common belief that diversifying reduces portfolio volatility.
Optimal Risk-Adjusted Performance at 20 Stocks:
— The Sharpe ratio peaks at 0.89 for the 20-stock portfolio, indicating that it provides the best risk-adjusted return among the options. The Sharpe ratio decreases slightly as more stocks are added.
— This suggests that a 20-stock portfolio strikes a good balance between return and risk.
Drawdown and Recovery Patterns:
— The worst month return, maximum drawdown, and drawdown periods (days) highlight how portfolios of different sizes handle downturns.
— The 20-stock portfolio experienced a maximum drawdown of 34.3%, which is less severe than smaller portfolios (e.g., 43.9% for a 5-stock portfolio). However, larger portfolios (80 stocks) manage to reduce this to 29.6%.
— Drawdown days remain similar after 15 stocks, suggesting that beyond this point, diversification doesn’t significantly affect the time it takes to recover from losses.
Therefore the first key insight we can draw that 20 Stock Portfolio is optimal
offering a balance of high returns and reasonable risk and highest risk to reward ratio.
Optimal Holdings Portfolio Size for Sharpe Ratio of each universe:
— As the universe increases, so does the number of ideal holdings in the portfolio.
— The Sharpe ratio, improves significantly as the number of holdings increases. The Sharpe ratio increases from 0.73 for 15 stocks in a universe of 200 to 0.97 for 45 stocks in a universe of MSC400.
— Interestingly, the 25-stock portfolio in both the 625-stock universe and the MSC400 universe delivers high Sharpe ratios of 0.91 and 0.97, respectively. This suggests that 25 stocks is an ideal portfolio size for maximizing risk-adjusted returns, especially when selecting from larger universes of stocks.
Balancing Risk and Returns with 20 to 25 Stocks:
— A 20- to 25-stock portfolio strikes the optimal balance between risk and return. For instance, with 20 stocks in the 500-stock universe, the portfolio achieves a Sharpe ratio of 0.92 and a historical annual return of 37.11%.
— With 25 stocks in the MSC400 universe, the Sharpe ratio reaches 0.97 with a historical return of 37.80%.
Conclusion:
In conclusion, a portfolio of 20 to 25 stocks seems to be the most efficient and effective size for balancing risk and return, making it the ideal number of holdings for most investors.
The ideal number of stocks in your portfolio depends on the stock universe you are investing in and your goals. If you are investing in a smaller, high-quality universe like MSC400, holding around 20–25 stocks can be highly effective.
Watch the full video on youtube here: https://youtu.be/UMzIfAvA224?si=TErWKxvWXSMoPdln
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