Question

Typical finance textbooks purport that when you construct a diversified portfolio of about 30 stocks, you will eliminate all the unsystematic risk in the portfolio. Go to Motley Fool's website and explain their position about this number. What do they recommend as the optimal number of stocles to hold in a portfolio? What is their argument for this number? If you have your own opinion and/or experience, please share it.

Answer 1

As per modern portfolio theory. There is a Benefit of diversification of risk when non-perfectly correlated stocks are added in the portfolio.

The benefit of diversification is when non perfectly correlated stocks are added then if the stock return of stock falls then it's offset by a rise in the stock return of another stock.

As per the motley fool when the portfolio contains 20 similarly weighted stocks then total risk (standard deviation/variance) of the portfolio decreases by up to 70%. Further increase in the number of stocks does not provide significant diversification/risk reduction benefits.

More than 20 stock, let's say, 40 or 50 stocks are difficult to research and manage in a portfolio by the retail investor. It creates more risk of not choosing a great business.

In my opinion, anywhere between 15 to 18 stocks are optimum for creating a well-diversified Portfolio because too many stocks make it difficult to track it.
The stocks must be equally weighted and covering almost all the major industries.