Last Updated on December 30, 2020 by Oddmund Groette
Like most things in the world, everyone has their opinion on basically everything. Why would dividend stocks be any different? Most commonly asked questions while building a portfolio is over the number of stocks one should own and the parameters over which their holdings should be diversified.
We believe a dividend investor should own at least 20 stocks. However, we recommend diversifying to ETFs and mutual funds as well. Don’t try to be smart when you are saving for your retirement.
There is no such thing as a structure of guidelines built for every investor to follow in order to make their investment portfolio a raging success with great profits. But investors should be aware of the unnecessary risks associated while building their dividend portfolios.
There are tons of factors that influence a portfolio’s success in delivering greater earnings and yes, the number of dividends is one of them, but the purpose behind the concept is to diversify the unnecessary risks away. Let’s get a little into the details.
It comes as a basic question the very need to build a portfolio altogether. What explains the need to analyze and evaluate more than just a couple of stocks. It would be relatively much easier to just completely invest in one or maybe two companies that an investor really likes.
For starters, luck and a volatile nature come automatically while investing. It’s one of those characteristics that a person has no control over. In a world where change is probably the only constant and unpredictability is written at the very core, even the experts of the field can be wrong when it comes to dividend stocks and investments.
It actually all comes together to an individual’s tolerance for risks. Not a lot of individuals have what it takes to breathe through the volatility and fluctuations in the market and generally, it is advised for investors to stay in their comfort zone supported by their knowledge. But diversifying stocks really does help strengthen your portfolio against those very risks.
So by basic rules of probability, for every company’s stock in your portfolio that is suffering, you would also have as many stocks that are experiencing great news. So in a way, a single stock won’t define the downfall or success of your investment returns and dividend income. And at the same time, your portfolio will come strong enough to take a few hits because of the diversity in stocks.
No one is asking you to buy every existing stock, it is quite impractical without the use of exchange-traded funds (ETFs), but the general idea and benefits of diversifying stocks should be clear and it helps dodge unnecessary risks that heavily influence a portfolio’s returns.
There are certain factors as I mentioned above, that greatly influence the fluctuations that come in a portfolio’s return and the number of stocks owned is one of them. The following risk factors deeply impact a portfolio’s performance, particularly in stressful market conditions:
- Number of Holdings
- Correlation between the Holdings
- Financial leverage
- The market cap of each Holding
Number of stocks to hold
As an investor, not everyone can have resources anywhere near similar to Warren Buffett. Nor do we generally have the right connections and insights which are much needed to effectively construct a portfolio. For this very reason, investors try to distribute their bets in a reasonable range of stocks that are different from each other. This helps avoid the ramifications that come with putting all your eggs in one basket.
From here the most common question arises, how many stocks should an investor own in order to maximize their benefits that come with diversification. The idea is that the lesser stocks an investor holds, the higher are the chances of his portfolio to diverge from the market’s return.
There have actually been many academic studies that researched and evaluated the responsible number of stocks to own. An article written by the American Association of Individual Investors (AAII) went ahead to mention that company-specific diversifiable risk should be decreased by the below-mentioned amounts:
- Holding 25 stocks reduces diversifiable risk by approximately 80%
- Holding 100 stocks reduces diversifiable risk by approximately 90%
- Holding 400 stocks reduces diversifiable risk by approximately 95%
Another study and a more recent one titled Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets, written by Francis Tapon and Vitali Alexeev, released in 2014, published notable findings. The first finding was that during financial distress more stocks are needed to diversify the risks, and the second finding was that correlations increase. The main reason for increased correlations is probably that the market falls quickly, while rises slowly. Within the US, researchers found that in order to be confident in decreasing 90% of the diversifiable risks 90% of the time, the average number of stocks needed is 55. But in a situation where market conditions are in distress, the number of stocks required goes over 110.
With the above-mentioned studies, it seems viable to conclude the average number of stocks needed should be between 25 and 100. However, more factors should be considered apart from just diversification. Investors should look into their own financial situations like the amount of time they can invest in research, size of the portfolio, trading costs, etc. There is ample evidence pointing out that small private investors underperform the market substantially. We suspect the main reasons are a lack of diversification and gravitation toward high-risk stocks. In order to play it safe, we recommend adding some ETFs and mutual funds to your portfolio.
In a general opinion, even owning somewhere between 20 and 60 stocks can provide enough balance between diversification, trading costs, and time devoted to research. But it’s highly important to remember that every individual investor has their own opinions over diversifying risks based on their tolerance.
It is important to remember that not only one factor can justify the success and downfall of your portfolio. There are many elements influencing returns and even more things to consider while investing in dividend stocks. Many investors do make the mistake of chasing after dividend yield but the ratio barely represents enough information to hold for long term earning.
Factors mentioned above should be used based on personal situation and opinion. Risk tolerance and comfort zone should not be taken lightly. It is a smart decision to diversify based on more than just numbers. Looking into different sectors makes up for a robust portfolio capable of making great earnings in the future. And finally, diversify your portfolio on the basis of different investments like real estate, bonds, international securities, etc.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.