Investment: How many Stocks should you own? (Part 1)

The answer is a lot more, and a lot fewer, than you probably think.

By Jason Zweig, Money Magazine senior writer/columnist

With the market near record highs and yet bouncy as a beat-up couch, you may be thinking it's time to focus on a small number of stocks that you know really well. What better way to keep returns up and risk down?

Conventional wisdom and new academic research certainly seem to suggest
that this is the way to go. Many financial planners and brokers will tell you that a portfolio of as few as 12 stocks (and up to 30) will
sufficiently diversify your (entire) holdings. (aC: The benefits of Diversification can be measured mathematically by the correlation coefficient of a portfolio; There is diversification benefit only if the addition of a new stock to a portfolio leads to a decrease in the overall correlation coefficient of a portfolio. So, the above study is saying that the addition of an additional stock (or more) to a portfolio of 30 stocks will not lower the overall correlation coefficient, and hence there is no diversification benefit from doing so.)

And three recent studies have found that individuals who own fewer stocks do better than those who own many.

However, as is often the case with conventional wisdom (and academic research), there's a lot more to the story. Fact is, if you build your portfolio entirely on the principle of "less is more," you're a lot more likely to end up with less than more. Here's why and what to do instead.

Those were the days
The idea that 12 to 30 stocks are all you need dates back at least to the 1960s, when academics, including Burton Malkiel, author of the classic "A Random Walk Down Wall Street," concluded that that's what it took to eliminate most of the risk from a portfolio. (They usually defined "risk" as the chance of suffering big swings away from the average market return.) (aC: Or even more specifically, it is defined as "unsystematic risk" - the kind of risk that can be diversifed away by adding certain uncorrelated stocks to an exisitng portfolio. There's also another kind of risk known as "systematic risk" that cannot be diversified away.)

But back in the days of hula hoops and transistor radios, and before computer-generated trading became common, stocks didn't bounce around the way they do today. In 2001, Malkiel found that it took 50 stocks to get the risk reduction that 20 used to provide. Others estimate that true diversification requires hundreds of stocks.

The focus factor
Just recently, however, researchers studying the performance of individual investors have discovered something that, at first glance, seems electrifying: The more concentrated a portfolio is, the higher the returns. One study found that investors whose portfolios were dominated by one or two stocks outperformed the most diversified stock owners by 0.8 to 4.8 percentage points annually on average. That's a huge gap. And roughly 8 percent of the top performers had portfolios concentrated in a single stock.

(aC: If you look at the definition of risk as defined above, you can see that risk may not neccessarily be a bad thing. If risk is the fluctuation around a certain mean/average return value, then this fluctuation can also be positive. In other words, becasue of the added risk, your portfolio returns can be higher. This is the basis for the saying - "Higher Risk; Higher Returns")

Continue here.