It’s all happening. You’ve got the job. You’ve got a place to live. Now you’ve got some expendable cash and you might be ready to play the stock market and invest some of your hard-earned money.
When it comes to stocks, the average person has a lot of questions. No wonder: financial literacy is not typically emphasized in public education. Only 17 states require high school students to take a course in personal financial literacy, according to a 2018 study by the Council for Economic Education. That leaves many people asking themselves, How many stocks does the average person own? How many different stocks should I own? How do I diversify?
The short answer is, owning more than one stock will diversify your investment, and diversification is one of the most important concepts in building a portfolio. Diversification means, quite simply, having a variety or diversity of holdings within a portfolio or between portfolios.
Portfolio diversification can come in two forms:
• investing in a diverse array of assets (stocks, bonds, real estate, etc)
• Owning, for example, shares of many different companies and different types of companies (large, medium, and small companies, international and domestic, shares of companies in different industries, etc) within a portfolio of stocks or bonds.
How Many Different Stocks Should You Own?
Diversification is known as the “only free lunch,” a supposed impossibility in economics and finance. This means that by spreading out a portfolio across different assets or kinds of a single asset, you can aim toincrease the expected return of a portfolio while not also driving up the risk.
Diversification spreads out the risk that a given company or asset will do poorly for an idiosyncratic reason (an executive gets hit by bus, a building burns down) across many assets, decreasing the possibility that the value of your stock holdings could get tanked by something that is impossible to foresee.
Diversification aims to smooth out volatility. If you own stocks for companies in different industries, when one sector gets hit—say, commodity prices crash in mining—stocks in a different sector where commodities are a major cost, like manufacturing, can go up. This can also be true across different types of investments, which don’t always move in the same direction.
How Many Stocks Should You Have in a Diversified Portfolio?
When it comes to a properly diversified stock portfolio, estimates on the number of stocks to include vary wildly. While some academics estimate that one gets the benefits of diversification from owning as few as 12 to 18 stocks and a popular rule of thumb is that stock diversification can be achieved with 15 stocks, another academic estimate puts the figure for diversification 83 to 99.
For stock funds—large collections of stocks managed by professionals and invested in by individuals and institutions—the average number of stocks held is77.
In considering diversification across assets, it makes sense to consider individual risk thresholds. One example is a typical investment approach used for retirement: A portfolio might be more heavily tilted towards stock when the individual is younger and can wait for those investments to grow, transitioning away from stocks over time as the individual’s risk tolerance goes down and they get closer to drawing on that money for retirement.
Getting the Right Balance in Your Stock Holdings
Another approach to diversification is to largely invest in large indexes, which track entire industries or even the entire market. Innovations like index funds, which are mutual funds that track indexes, and exchange-traded funds (ETF), which can be bought and sold like stocks, have made it simpler for investors to achieve diversification according to their goals, in a single investment vehicle.
Balancing a Portfolio Through Index Funds
When John “Jack” Bogle, founder of the Vanguard Group, created the Vanguard 500 Index Fund in the 1970s, it was the first of its kind. His vision was to put investors in the driver’s seat by offering them a low-cost way to invest in the entire market.
The Vanguard 500 Index Fund is a mutual fund that tracks the entire S&P 500, a collection of 500 large cap stocks and is used as a general barometer for the health of the market. These companies are distributed across numerous industries, like information technology, finance, healthcare, and energy.
Today, index funds seek to track either the S&P 500 or the Russell 2000, taking investor capital and buying every stock in that index. They typically have to buy the stock in accordance with its “weight” in the index, typically its market capitalization, or the overall value of a publicly traded company’s shares. This means that the fund will be more heavily invested in the shares of the more valuable companies in that index.
Index funds make it easy for the average investor to buy into the market and achieve instant diversification. They’re affordable, too, with lower fees thanks to taking expensive fund managers out of the equation.
Diversifying through ETFs
The first ETFs were launched in 1993, and since then they’ve become one of the most popular vehicles for investors—in part because they come with a lot of the same benefits of index funds, like low fees and instant diversification.
ETFs might be the closest thing to automatic investing or investing in easy mode. While an ETF can be bought and sold like a stock, they don’t need to be made up of stocks. ETFs can be made up of bonds, commodities, or even currencies.
ETFs allow an investor to track the overall performance of the group of assets that the ETF is made up as—and, like a stock, the ETF’s price changes constantly based on the volume and demand of buying and selling throughout the day. ETF “sponsors,” the investment companies that create and manage the funds, rely on complex trading mechanisms with other sophisticated participants in the market to keep an ETF’s value very close to the value of the underlying components (the stocks, bonds, commodities, or currencies) that it’s supposed to represent.
Choosing Stocks vs. Investing in Funds
When it comes to buying individual stocks, there’s a lot to consider. And while there is available information about a given company—including its past financial results—that can inform a thoughtful decision, its value going forward will be determined by things that are unknown. Is the industry overall going to grow or shrink? Could the performance of that company be affected by political events overseas or at home? Are there potential disruptors who will eat up its current share of the market?
In addition, the performance of a company is not the same as the performance of that company’s stock. A company can have great, consistent profits in a growing industry and a politically placid environment. But the price of that stock might be high. When it comes to buying, it’s important to consider the potential of future price increases. If a stock has already done well in the past, the future growth and appreciation could be minimal.
In building a diverse stock portfolio on your own, you’ll likely go through this research and consideration process with many—possibly dozens—of stocks.
Index funds and ETFs offer instant diversification, taking the guessing game out of trying to buy stocks. What’s more, chances are if there’s something an investor is passionate about, there’s an ETF for that. There are funds for clean energy, ones that focus on machine learning and artificial intelligence, even ETFs focused on organic food and farming.
When it comes to investing in index funds, the process is a bit different. Once an investor figures out what kind of market they’d like to track—like all the stocks in the S&P 500—they can look at two important factors. The first is “tracking error”: How well does the fund track the value of the stocks it invests in? The second is cost. All things being equal, a less expensive fund, a fund with lower fees and lower costs devoted to marketing, trading, and compensation can mean more profits for the buyer.
No matter how an investor creates a diverse stock portfolio, it’s important to remember that all investments come with risks that include the potential for loss.
Diversification—investing in more than one stock or other investment—is an important consideration when building a portfolio. But building a diverse stock portfolio can be achieved in many different ways, whether an investor lets their passions for an industry or certain companies guide them, or they are attracted to the ease and low barrier to entry of an ETF. The key is to find the approach that works for each individual.
Once an investor has done the research, figured out what kind of diversification makes sense, and decided just how many stocks they should own, they might be ready to take the first steps to build a portfolio that’s just right. See how SoFi ETFs and active investing can help you get started on your goals.
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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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