Your Goldilocks Portfolio: How much Diversity is Just Right?

In the realm of investing, the quest for the perfect balance – a "Goldilocks portfolio" that's neither too risky nor too conservative – is an ongoing journey.
Central to this pursuit is the concept of diversification, particularly in terms of the number of holdings within a portfolio.
But in a world where investment options seem endless, how many stocks or investments are truly needed to achieve optimal diversification?

Let's delve deep into this question by examining different approaches and uncovering the nuances of finding that elusive middle ground.

The Concentrated Approach: Quality Over Quantity

Warren Buffett and Charlie Munger, two titans of investing, have long championed a concentrated portfolio approach. Their philosophy is rooted in the belief that exceptional returns come from deep knowledge and conviction in a select few investments.
Buffett famously quipped, "Diversification is protection against ignorance. It makes little sense if you know what you are doing." This approach typically involves holding around 20 stocks or fewer. The benefits of such a focused portfolio include:

1. Deep knowledge of each holding: With fewer companies to track, investors can develop a comprehensive understanding of each business, its competitive advantages, and its growth prospects.
2. Ability to monitor each investment closely: A concentrated portfolio allows for more frequent and thorough analysis of each holding, potentially leading to better-timed investment decisions.
3. Potential for outsized returns: If selections perform well, the impact on the overall portfolio can be significant.
4. Simplified decision-making: With fewer moving parts, investors can make quicker, more confident decisions about buying, holding, or selling.

Berkshire Hathaway (NYSE:BRKa), Buffett and Munger's investment vehicle, exemplifies this strategy. As of 2024, their portfolio consists of about 30 publicly-traded companies, with significant concentrations in a handful of positions. For instance, as of their last filing, nearly 50% of their portfolio was allocated to just five companies: Apple (NASDAQ:AAPL), Bank of America (NYSE:BAC), American Express (NYSE:AXP), Coca-Cola (NYSE:KO), and Chevron (NYSE:CVX).

However, it's crucial to note that this approach requires a high level of skill, experience, and emotional discipline. It also exposes the portfolio to higher company-specific risk, which can lead to increased volatility.

The Widely Diversified Approach: Casting a Wide Net

On the opposite end of the spectrum, we find investors like Peter Lynch, who managed Fidelity's Magellan Fund from 1977 to 1990. Lynch was renowned for his "buy what you know" philosophy, which often led him to hold over 1,000 stocks in his portfolio at times.

Lynch's approach was based on the idea that opportunities could be found anywhere, and that by "turning over a lot of rocks," an investor could uncover hidden gems. The advantages of this widely diversified approach include:

1. Reduced impact of any single stock's poor performance: With so many holdings, the failure of one or a few companies has a minimal effect on the overall portfolio.
2. Increased chances of holding "ten-baggers": Lynch coined the term "ten-bagger" for stocks that increase tenfold in value. By holding a large number of stocks, the chances of having a few of these exceptional performers in the portfolio increase.
3. Broader market exposure: A widely diversified portfolio can provide exposure to various sectors, market caps, and geographic regions, potentially capturing gains across different market segments.
4. Lower volatility: Generally, a portfolio with more holdings will experience less dramatic swings in value compared to a concentrated portfolio.

Lynch's approach proved remarkably successful, with the Magellan Fund averaging a 29.2% annual return during his tenure, significantly outperforming the S&P 500.

However, this strategy also comes with challenges:
1. Difficulty in maintaining in-depth knowledge of all holdings
2. Potential for over-diversification, leading to returns that closely mirror the overall market
3. Higher transaction costs and more complex portfolio management


Finding the Middle Ground: The Optimal Portfolio Size

While both concentrated and widely diversified approaches have their merits, most investors and researchers suggest a middle ground. The key question is: at what point do the benefits of adding more stocks to a portfolio begin to diminish?

Several academic studies have attempted to answer this question:

1. Elton and Gruber's research suggests that a portfolio of 20-30 stocks can eliminate about 95% of the diversifiable risk in a portfolio. This study has been widely cited and forms the basis for many arguments in favor of relatively concentrated portfolios.
2. A more recent study by Statman (2004) argues that the optimal number for a well-diversified portfolio is actually closer to 300 stocks. Statman's work considers not just risk reduction but also the potential for higher returns through exposure to a broader range of stocks.
3. Domian, Louton, and Racine (2007) found that portfolios of 50-100 stocks were necessary to minimize the risk of underperformance over longer holding periods.

The discrepancies in these findings highlight that the "optimal" number can vary based on several factors:

1. Investment style (active vs. passive): Active managers may prefer fewer holdings for easier management, while passive strategies often include more holdings to track an index.
2. Market cap focus: Large-cap portfolios may require fewer stocks to achieve diversification compared to small-cap portfolios, as large-cap stocks often have more diversified business models.
3. Geographic scope: Portfolios focused on a single country may need fewer holdings compared to global portfolios aiming for geographic diversification.
4. Sector allocation: Some sectors are more volatile or cyclical than others, potentially requiring more holdings to achieve proper diversification.
5. Time horizon: Longer investment horizons may benefit from more diversification to minimize the risk of sustained underperformance.


Practical Considerations

When determining your ideal number of holdings, consider the following practical aspects:

1. Management time and costs: More holdings require more time to monitor and potentially higher transaction costs. For individual investors, this can be a significant constraint.
2. Position sizes: In a concentrated portfolio, each position has a larger impact on overall returns. This can be beneficial when picks perform well but can also increase risk.
3. Use of funds and ETFs: These can provide diversification with fewer individual holdings. For example, holding 10-20 well-chosen ETFs can provide exposure to thousands of underlying securities.
4. Rebalancing complexity: More holdings can make regular rebalancing more time-consuming and potentially more costly.
5. Tax implications: For taxable accounts, a larger number of holdings can complicate tax-loss harvesting and increase the likelihood of wash sales.

Building Your Goldilocks Portfolio

The "right" number of holdings depends on your personal investment style, goals, and resources. Here are strategies for different investor types:

1. The focused investor (20-30 stocks):
- Suits those who enjoy deep research and have high conviction in their picks
- Requires significant time commitment for research and monitoring
- Potentially higher risk but also higher reward potential
- Example strategy: Identify 5-7 core holdings (60-70% of portfolio) and 15-20 satellite positions
2. The moderately diversified investor (50-100 stocks):
- Balances concentration with broader diversification
- May combine individual stock picks with sector or thematic ETFs
- Allows for some high-conviction picks while maintaining overall diversification
- Example strategy: 20-30 individual stocks (50% of portfolio), 10-15 sector/thematic ETFs (40%), and broad market ETF (10%)
3. The broadly diversified investor (100+ stocks):
- Ideal for those seeking market-like returns with lower stock-specific risk
- Often achieved through a combination of broad market ETFs and some individual stocks
- Lower management intensity but may require discipline to avoid frequent trading
- Example strategy: Core position in total market ETF (60%), international ETF (20%), and 20-30 individual stock picks (20%)

Tools and Techniques

To assess and maintain your desired level of diversification:

1. Portfolio analysis tools: Use platforms like Morningstar, Personal Capital, or your brokerage's native tools to evaluate sector exposure, geographic distribution, and correlation between holdings.
2. Regular rebalancing: Implement a systematic rebalancing strategy (e.g., quarterly or when allocations drift beyond set thresholds) to maintain your target allocation.
3. Core-satellite approach: Combine broad market ETFs (core) with individual stock picks or specialized ETFs (satellite) to balance diversification with the potential for outperformance.
4. Risk analysis: Regularly assess your portfolio's beta, standard deviation, and other risk metrics to ensure they align with your risk tolerance.
5. Correlation matrix: Periodically review the correlation between your holdings to ensure you're achieving true diversification across assets that don't all move in lockstep.


Wrapping this up, the Goldilocks portfolio – with just the right amount of diversity – is a personal journey that evolves with your investment knowledge, risk tolerance, and life circumstances. While research suggests that most diversification benefits can be achieved with 20-100 holdings, the exact number depends on your unique situation. 

Personally, I employ a mix of both Buffett/Munger (good management, safety margin, moat) and Peter Lynch's (more than 60 consitituents) approaches . With a touch of John C. Bogle's management system of ousting the weakest performers every year. 

Whether you lean towards Buffett's concentrated approach, Lynch's wide-net strategy, or somewhere in between, the key is to find a balance that allows you to sleep well at night while still achieving your financial objectives. Regularly reassess your portfolio to ensure it remains aligned with your evolving needs and market conditions.

Remember, in investing, as in the story of Goldilocks, the goal is to find what's "just right" for you. This means not only considering the number of holdings but also ensuring that your portfolio reflects your investment thesis, risk tolerance, and long-term financial goals.

As you refine your Goldilocks portfolio, keep in mind that diversification is just one tool in the investor's toolkit. It should work in concert with other fundamental principles such as asset allocation, cost management, and a long-term perspective to create a robust investment strategy that can weather various market conditions and help you achieve your financial aspirations.