Investing Classroom: How much is enough?

Most of us collect something. For some, it's rare coins. For others, it's stamps. Still others collect clothes.

Some people collect investments. They may own a dozen funds, others might own these funds and 25 or so stocks. That's a lot of investments.

The problem with owning too many funds and stocks is that you can easily lose sight of the wood for the trees. You start out as an investor with an investment goal and a portfolio tailored to you and turn into a collector who has forgotten what your goals are.

This lesson will cover how to know when enough is enough.

How many stocks you ‘need’
Diversification seekers always want to know what the optimal number of investments is. They want to have enough holdings to moderate the volatility of their portfolios. But they don't want too many holdings, because they think they're diluting their possible returns and overcomplicating their investing lives.

When it comes to stocks, various studies have suggested that you can adequately diversify a portfolio with 15 to 30 stocks. In his 1930s classic, The Intelligent Investor, Benjamin Graham said that the magic number was somewhere between 10 and 30 names. In the late 1960s, John Evans and Stephen Archer concluded that 10 stocks were enough. And in the 1970s, Burton Malkiel said 20 stocks will do in A Random Walk Down Wall Street.

Don't let these numbers mislead you, though. For starters, most of these "how many stocks" stories assume random investing--and investing is anything but random, unless you're the type who chooses investments by throwing darts at stock tables. We all have our own investment styles.

Perhaps more important, however, is that recent studies, including one by Malkiel himself, show that the volatility of stocks has risen over the past few decades. Additionally, individual stocks are behaving less like other individual stocks. As a result, the number of stocks you need to mute volatility likely is far greater than 15.

How many funds you ‘need’
What about funds--how many funds do you need to have a diverse enough portfolio? To find out if more funds mute volatility the same way more stocks do, Morningstar created hypothetical portfolios ranging from one to 30 funds, using every possible permutation of funds. We then calculated five-year standard deviations for each of those portfolios. Higher standard deviation can spell bigger gains or losses, while a lower number indicates a less volatile portfolio.

Morningstar found that single-fund portfolios had the highest standard deviation, delivering either the biggest gains or the heaviest losses. So owning just one fund can be a risky bet. Add a fund and the standard deviation drops significantly. Returns are lower, but the downside is less severe, too.

After seven funds, however, a portfolio's standard deviation stays pretty much the same regardless of how many funds you add. In other words, once you own seven funds, there may be no need for more.

Of course, the same caveats that apply to studies of how many stocks you need also apply here.

What you really need: Diversification
But the number of securities you own is less important than how diverse those securities are. Seven large-growth funds won't diversify your portfolio the same way owning one large-blend fund and one small-value fund and one small-growth fund would.

Use Morningstar.co.uk's Portfolio Manager to analyse your current portfolio, if you have one. Use the same tool as you're assembling a portfolio, too, to see if your choices are as diverse as you think they are.

You're looking for two things: Funds and stocks that invest in the same way, and holes in your portfolio. More than one large-growth fund or wireless stock, for example, won't add much to your portfolio.

The odds are pretty good that if you own multiple investments doing the same thing or you are considering investments that do the same thing, one is better than the others. Focus your money on the best choices.

Don't forget that you can have overlap even though you own just a small number of securities. Conversely, even if you own a lot of investments you could still have gaps in your portfolio.

The bottom line: Don't obsess over the number of securities that you own. Instead, concentrate on their diversity.