In contrast to a limited number of asset classes, the universe of individual investments is huge. Which raises the question:
How many different investments should you own to diversify your portfolio broadly enough to manage investment risk?
There is no simple or single answer that is right for everyone. Whether your stock portfolio includes six securities, 20 securities or more is a decision you have to make in consultation with your investment professional or based on your own research and judgment.
In general, the decision will depend on how closely your asset classes, and investments within each asset class, track one another’s returns—a concept called correlation.
>>Example: If Stock A always goes up and down the same amount as Stock B, they are said to be perfectly correlated. If Stock A always goes up the same amount that Stock B goes down, they are said to be negatively correlated. In the real world, securities often are positively correlated with one another to varying degrees. The less positively correlated your investments are with one another, the better diversified you are.
Building a diversified portfolio is one of the reasons many investors turn to pooled investments like stock and bond funds—such as mutual funds, exchange-traded funds, and the investment portfolios of variable annuities.
Pooled investments typically include a larger number and variety of underlying investments than you are likely to assemble on your own, so they help spread out your risk. You do have to make sure, however, that even the pooled investments you own are diversified—for example, owning two mutual funds that invest in the same subclass of stocks won’t help you to diversify.
With any investment strategy, it’s important that you not only think carefully about your asset allocation and make sure to diversify your holdings when you establish your portfolio, but you also must stay actively attuned to the results of your choices.
A critical step in managing investment risk is keeping track of whether or not your investments, both individually and as a group, are meeting reasonable expectations. Be prepared to make adjustments when the situation calls for it.