Portfolio Guide
Diversification vs concentration: how many holdings is enough?
Concentration can magnify good research and bad luck alike. Diversification reduces the damage from any single mistake. The right mix is a decision, not a default.
There is a long-running argument in investing. One side says concentrate: put your money into your best few ideas, because spreading it thin dilutes your best work. The other says diversify: no one knows enough to bet heavily on a few outcomes. Both sides have a point. The useful question is not which side is right but how much single-idea risk you can afford to carry.
What concentration does to a mistake
The damage a single holding can do depends on its weight in your portfolio. An illustrative comparison, in which one holding falls 50%:
| Portfolio structure | Weight of that holding | Portfolio decline |
|---|---|---|
| 2 equal holdings | 50% | 25% |
| 5 equal holdings | 20% | 10% |
| 10 equal holdings | 10% | 5% |
| 20 equal holdings | 5% | 2.5% |
A 25% portfolio decline needs a 33.3% gain to recover; a 2.5% decline needs about 2.6%. Our drawdown recovery guide explains the math. The same logic works in reverse: a big winner also moves a concentrated portfolio much more. Concentration magnifies outcomes in both directions.
Count is not the same as diversification
Owning many holdings only reduces risk if they do not all respond to the same things. Twenty stocks in one industry, or twenty companies that all depend on low interest rates, can fall together. Meanwhile a smaller number of holdings exposed to genuinely different drivers can be more diversified.
To check your real diversification, list what drives each holding:
- Sector and industry.
- Sensitivity to interest rates and to economic growth.
- Exposure to a commodity, a currency or a single country.
- Dependence on one large customer, supplier or product.
Then add up the weights by driver. If one driver accounts for most of the portfolio, that is your real concentration, whatever the number of line items.
When concentration can make sense
A more concentrated portfolio can be reasonable when the investor genuinely understands each business deeply, has done original research, can tolerate large swings without selling, and does not need the money for a long time. Even then, careful investors usually cap any single position and size each by its specific risk. Our guide to position sizing shows how.
When more diversification makes sense
Broader diversification tends to suit investors who are still learning, who cannot spend much time researching individual companies, who have shorter horizons, or who know they find large swings hard to sit through. Broad funds are one common way to get it cheaply, though they carry their own risks and costs that you should read about before buying.
Setting your own limits
Rather than picking a number of holdings, set three limits and write them in your investment policy:
- Maximum weight per holding: the largest share of the portfolio any one position may reach before you trim it.
- Maximum weight per driver: the largest share that may depend on one sector, theme or factor.
- Maximum loss per idea: the planned loss at which you exit or reassess.
These three numbers say more about your risk than the count of holdings ever could.
Watch for drift
A portfolio can become concentrated without you deciding it. A winning stock that doubles while the rest stay flat may grow from 10% to nearly 20% of the portfolio. That success is welcome, but it also means one company now carries much more of your outcome. Review weights on a schedule and trim positions that exceed your limits, after considering any taxes and costs. Our guide on building a portfolio covers rebalancing rules.
A quick self-test
Take your three largest holdings and ask what single event would hurt all three at once: a rise in interest rates, a fall in consumer spending, a drop in a commodity price, a slowdown in one industry. If you can name one easily, add up their combined weight. That figure, not the number of line items, is a better guide to how concentrated you really are.
Repeat the test at every scheduled review, because weights and the drivers behind them change as markets move and as you add new holdings over time.
The bottom line
Concentrate only as much as your knowledge, time horizon and nerves can support. Diversify by what drives your holdings, not by how many there are. And write the limits down before a big winner or a painful loser tempts you to change them.
Sizing, concentration and when to add or exit are covered in chapter four of our ebook How to Choose Investments, Manage Risk, and Build a Portfolio: With the Money You Have, with two complete worked scenarios.
Questions readers ask
How many stocks do I need to be diversified?
There is no single number. What matters is whether your holdings depend on different drivers and how large each position is. Many holdings in one sector can be less diversified than fewer holdings across different ones.
Is a concentrated portfolio riskier?
A concentrated portfolio usually swings more, because each holding has a larger effect on the total. It magnifies both good and bad outcomes.
What should I do when one stock becomes a large part of my portfolio?
Compare its weight with the limits in your written policy. If it exceeds them, consider trimming it back after checking the tax and cost effects in your account.
Educational material from The Company Chronicle, not individualized investment advice. Investing involves risk, including loss of principal. Examples are illustrative.