Many people believe they have too little money in their investment portfolio to own individual stocks. They feel that mutual funds give them the "safety" of diversification. I often review portfolios for prospects and find that they are invested in five, six, ten different mutual funds. The prospects believe they are adequately diversified; after all, they own multiple mutual funds which hold one hundred plus stocks each on average. They are often surprised when I tell them that they are not very well diversified at all. They are down right disbelieving when I tell them they could get almost the same diversification with a portfolio of 25 carefully chosen stocks. The reality is that 15 to 25 well chosen stocks provide 90% of the benefits of diversification and that a 40 stock portfolio can provide 99% of the benefits of diversification. The hundreds of additional stocks owned by the mutual funds in which our prospects are invested provide almost no additional diversification benefits. Have $100,000 allocated to equities? More than enough to build a 25 stock portfolio that will adequately diversify away your non-systemic (company-specific) risk. However, you aren't properly diversified just because you own a properly diversified stock portfolio.
A properly diversified stock portfolio provides nowhere near the diversification benefits of investing among different asset classes. Small, large, domestic, and international stocks are sub-asset classes, not truly separate asset classes. After all, stocks tend to move together because companies tend to prosper or suffer together as economies expand or contract. Rather than limiting oneself to a single asset class, investors should build a properly diversified portfolio containing all four major asset classes (the historical data indicates that a four asset class portfolio composed of stocks - domestic and international, bonds, real estate, and commodities provides high levels of return per unit of risk).
The famous Brinson, Hood, and Beebower (BHB) study done in 1986 indicated that approximately 92% of a portfolios' variation of returns is due to the mix of asset classes chosen. BHB used stocks, bonds, real estate, and cash in their study. Simply put, the percentage of each asset included in your portfolio will go a long way in determining your returns and the volatility of your returns over the long run. Individual security selection and market timing are not major determinants of long run returns and variation of returns relative to the asset classes in which you choose to invest. (Importantly, the value style of investing does outperform so-called growth and momentum styles over the long run and therefore does add to an investor's returns).
Consider that approximately 80% of actively managed stock mutual funds don't beat their benchmarks. Most large cap funds don't beat the S&P 500 index (large cap). Most small cap funds don't beat the Russell 2000. Furthermore, the funds that do beat their benchmarks vary from year to year and there is no evidence whatsoever that a savvy financial advisor can pick a priori (in advance) which funds will outperform (Connecting the dots - your financial advisor or planner is blowing smoke when he confidently informs you that he'll only put you into the best mutual funds, since he can't possibly know which ones those will be. Unfortunately, too many financial advisors put their clients in mostly, or only, stock mutual funds and they tend to use the ones with the highest commissions!)
Okay, to review: a 25 stock portfolio will get you 90% of the benefits of diversification and a 40 stock portfolio will get you 99% of the benefits (assuming diversification is your goal). But is that a properly diversified portfolio? Stock portfolio - yes, investment portfolio - NO!
Multiple-Asset-Class investing offers demonstrably superior results to investors, providing high rates of return with less volatility than one, two, and three asset class portfolios. For instance, an equally weighted four asset class portfolio (composed of domestic stocks, international stocks, bonds, and commodities) returned 11.24% per annum from 1972 through 2008 with a standard deviation of only 14.11%, resulting in a Sharpe ratio of 0.46 (high). What that means for us individual investors is that we want to create portfolios containing stocks (domestic and international), bonds, real estate and commodities for the long-term. Importantly, we can adjust volatility by adjusting the mix. Also importantly, we can add additional return by using value investing (paying less for a business than its worth) rather than growth investing (paying a premium for a business) or momentum investing (buying a stock simply because it is going up).
