Key Takeaways
- The risk-reduction benefits of diversification exhibit sharply diminishing returns, with most idiosyncratic risk mitigated by holding between 15 and 20 uncorrelated securities.
- Beyond this point, a portfolio’s risk profile becomes dominated by systematic (market) risk, which cannot be diversified away by adding more stocks.
- Excessive diversification can dilute the performance of high-conviction ideas and lead to a cognitive burden, hindering an investor’s ability to conduct thorough due diligence on each holding.
- A concentrated portfolio, while demanding superior research and psychological fortitude, remains a viable and often superior strategy for generating alpha over the long term.
The principle of diversification is one of the few concepts in finance treated as near-unassailable wisdom. Yet, a more critical examination reveals its limitations, particularly for the active investor seeking to outperform the market. A provocative assertion, recently articulated by the analyst known as ‘thexcapitalist’, suggests that extending a portfolio beyond 15 stocks provides no meaningful protection against systematic risk, framing excessive diversification as little more than “an insurance against ignorance”. This perspective, echoing the sentiments of investors like Warren Buffett, challenges the conventional wisdom that more is always safer and forces a re-evaluation of the relationship between concentration, risk, and returns.
The Mathematical Limits of Diversification
Modern Portfolio Theory provides the mathematical foundation for diversification. The core idea is that by combining assets with imperfect correlations, an investor can reduce portfolio-level volatility without sacrificing expected returns. The risk being reduced here is idiosyncratic risk—the company-specific factors like management missteps, product failures, or competitive pressures. However, the efficacy of this approach is not linear.
Academic studies have long demonstrated that the benefits of diversification plateau rather quickly. As more stocks are added to a portfolio, the reduction in standard deviation (a measure of volatility) becomes progressively smaller. While the precise number varies across studies, the consensus suggests that the lion’s share of idiosyncratic risk is eliminated once a portfolio contains approximately 15 to 20 well-chosen securities. Beyond this threshold, the dominant remaining risk is systematic, or market risk, which is driven by macroeconomic factors such as interest rates, inflation, and geopolitical events. No amount of additional domestic equity holdings can insulate a portfolio from a broad market downturn.
The table below illustrates this principle of diminishing returns. It shows a stylised representation of how portfolio risk decreases as the number of stocks increases, assuming equally weighted and randomly selected securities.
| Number of Stocks in Portfolio | Percentage of Total Risk (Approximate) | Risk Reduction from Adding One More Stock |
|---|---|---|
| 1 | 100% | N/A |
| 5 | 45% | Significant |
| 10 | 30% | Moderate |
| 15 | 24% | Marginal |
| 20 | 21% | Negligible |
| 30 | 20% | Insignificant |
| 100+ | ~19% (Approaches Systematic Risk) | Effectively Zero |
As the data indicates, the move from one to ten stocks drastically reduces risk. The move from 20 to 100, however, offers a trivial benefit. An investor with 50 or 100 stocks has not built a safer portfolio; they have built an expensive and inefficient proxy for a market index.
The Behavioural Costs of ‘Diworsification’
The term ‘diworsification’, popularised by fund manager Peter Lynch, aptly describes the negative consequences of diversifying for its own sake. When a portfolio becomes a sprawling collection of disparate holdings, it introduces new, often unquantified, risks.
Cognitive Dilution
The most significant cost is cognitive. A fundamental tenet of successful active investing is deep knowledge of the underlying businesses. An investor can realistically follow, analyse, and maintain conviction in a dozen or so companies. They can read every quarterly report, listen to earnings calls, and track industry developments. Can the same be said for a portfolio of 75 stocks? The answer is almost certainly no. Attention becomes fragmented, analysis becomes superficial, and the investor loses the very informational edge they sought to cultivate.
Dilution of Alpha
Furthermore, over-diversification inevitably dilutes the impact of an investor’s best ideas. If a manager’s third-best idea offers an exceptional risk-reward profile, but it only constitutes 1% of the portfolio, its potential contribution to overall returns is muted. A concentrated portfolio forces discipline; it ensures that capital is allocated only to the highest-conviction opportunities. Warren Buffett’s long-term success at Berkshire Hathaway was built not on owning hundreds of companies, but on making large, concentrated bets on a select few that he understood intimately.
Rethinking Portfolio Construction
This is not an argument against diversification itself, but against its mindless application. A thoughtfully constructed portfolio of 15 stocks across different, ideally uncorrelated, sectors can be remarkably robust. The goal is not to simply own more tickers, but to achieve genuine diversification of underlying business drivers. Owning five different consumer discretionary technology firms is not diversification; it is a concentrated bet on a single economic factor.
For the serious investor, the process should be inverted. Instead of starting with a target number of stocks, one should start with a rigorous filtering process to identify exceptional businesses trading at reasonable valuations. The final portfolio size should be a consequence of how many such opportunities can be found and adequately monitored. If that number is 12, 18, or 22, so be it. The goal is to build a portfolio of high-conviction ideas, not to fill predetermined slots.
This approach requires patience, discipline, and the psychological resilience to endure periods of higher volatility. A concentrated portfolio will, by its nature, deviate more significantly from its benchmark. But for those willing to do the work, it offers the only logical path to achieving returns that also deviate, in a positive direction, from the market average.
As a concluding hypothesis, consider this: in the current economic environment, characterised by higher costs of capital and a renewed focus on profitability, the performance gap between focused, high-quality portfolios and broad market indices will likely widen. The era of indiscriminate passive inflows lifting all boats is waning. In its place, a market that rewards deep fundamental analysis and conviction is emerging, creating a fertile ground for the concentrated investor.
References
Fidelity. (n.d.). Warren Buffett’s advice for serious stock-pickers. Fidelity.co.uk. Retrieved from https://www.fidelity.co.uk/markets-insights/investing-ideas/shares/warren-buffetts-advice-for-serious-stock-pickers/
Graham Value. (n.d.). Warren Buffett and diversification. Grahamvalue.com. Retrieved from https://www.grahamvalue.com/blog/warren-buffett-and-diversification
Investopedia. (2023, September 28). What did Warren Buffett mean when he said, ‘Diversification is protection against ignorance’? Retrieved from https://www.investopedia.com/ask/answers/031115/what-did-warren-buffett-mean-when-he-said-diversification-protection-against-ignorance-it-makes.asp
Kaufman, K. (2018, July 24). Here’s why Warren Buffett and other great investors don’t diversify. Forbes. Retrieved from https://www.forbes.com/sites/karlkaufman/2018/07/24/heres-why-warren-buffett-and-other-great-investors-dont-diversify/
Motley Fool. (n.d.). Is Warren Buffett right about the stock market? Here’s what investors should know. The Globe and Mail. Retrieved from https://www.theglobeandmail.com/investing/markets/markets-news/Motley%20Fool/33172701/is-warren-buffett-right-about-the-stock-market-here-s-what-investors-should-know
Rule One Investing. (n.d.). Warren Buffett: Diversification. Retrieved from https://www.ruleoneinvesting.com/blog/how-to-invest/warren-buffett-diversification/
@thexcapitalist. (2024, October 11). [Don’t over-diversify. Diversification beyond 15 stocks doesn’t provide you with additional protection against systematic risk]. Retrieved from https://x.com/thexcapitalist/status/1867922213019455758
