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How many assets do you need to own in your portfolio such that it has the smallest possible risk? New research says it's no more than 15 and possibly as few as 10.

"The smallest risk portfolios generally require no more than 15 assets," according to the authors of Why Small Portfolios Are Preferable and How to Choose Them, a report published in the Journal of Financial Perspectives. "Furthermore, it is almost always possible to find portfolios that are just 1% more risky than the smallest risk portfolios and contain no more than 10 assets."

According to the researchers, since the start of modern portfolio theory in the 1950s, with the seminal mean-variance model of Harry Markowitz, the main aim of portfolio selection models was that of reducing the risk of an investment in the stock market through diversification while trying to achieve a satisfactory return.

The researchers wrote: "The concept of diversification is not well-defined, and the measures of diversification are continuously evolving. However, the qualitative idea of diversification is to not overly concentrate the investments in very few stocks. Indeed, the role of diversification is to reduce risk by diversifying it as much as possible."

In their work, the researchers investigated the possible benefits and disadvantages of enlarging the portfolio size in several portfolio selection models with respect to various measures of performance. "Similar to various previous findings, but with a substantially different approach, our empirical results show that in most cases limiting the size of the selected portfolio improves both the in-sample and the out-of-sample performance," the researchers wrote.

They call this the small portfolio effect.

In light of the findings, we asked George Padula, the chief investment officer of Modera Wealth Management as well as an instructor at the Boston University Program for Financial Planners, to review the research.

Fewer Might Not Be Better

"Overall, the title seems to suggest that fewer is better and that may not be the case when thinking about building a portfolio," says Padula. "It may work for their subset of assets using their definition of risk, but it doesn't tell the whole story."

So, what is the whole story?

In their research, the authors didn't focus on using core funds and ETFs to build a portfolio.

That, Padula says, would have made sense.

"Own a few core funds and build a diversified portfolio that way," he says. "For many investors, there is the paradox of choice; too many funds, ETFS, bonds, and stocks to choose from. The increased assets in 'total market,' or 'core' funds and ETFs can help investors overcome this issue, get diversification, allow for the ownership broad asset classes in a cost-effective, tax-efficient manner.

Instead, the researchers focused only on stocks and not on other asset classes. "I think that there are some implications from the paper that readers need to be careful about if concluding that 'fewer' is better," says Padula. "They do not consider bonds, REITs, or other securities in developing a portfolio."

In fact, the paper deals with only a small subset of the investments available for a portfolio. "The paper says nothing about building a portfolio of multiple asset classes for investors who may be looking for not only risk reduction, but who also have multiple real goals such as income generation, retirement, college funding, etc.," he says.

Easier Said Than Done

Also, picking just 10 to 15 stocks sounds great on paper, but it might prove more difficult. "While the authors conclude that 10 to 15 'assets' are optimal using their methodologies," says Padula, "how many investors have the time, knowledge and resources to choose those 10 to 15 out of a universe of 500-plus stocks if using the S&P 500 or close to 2,000 stocks if including mid- and small-caps?"

And that's just in the U.S. "It's like trying to find 10 needles in not just one haystack, but multiple haystacks," he says.

Padula says the authors do a good job articulating why small portfolios are preferable, but fail at describing how to choose them. "Good theory, but how does one implement it, which is where the rubber meets the road," he says.

Padula also says the paper seems to confirm modern portfolio theory rather than refute it. "As the authors note, Eugene Fama and others say that the benefits of diversification improve significantly up to about 20 stocks and then the additional benefits seem to level off."

The author's research says the same thing, albeit defining risk slightly differently, seeming to indicate that 10-15 assets can be used to gain the same benefits of diversification before those benefits slow down, says Padula. "They use a different definition of risk reduction, but the generality of the trend is in the same direction: adding assets to a portfolio should reduce risk. They are simply saying one needs fewer assets than what others feel is necessary."

The researchers also seem to be asking if one really needs to own the "market" when a sample will do. "That's a fair question but how does one decide what the sample should be?" asks Padula. "How does one define the 'market' itself? Is the market U.S. stocks, or international stocks, or industry groups? There are issues of transaction costs, liquidity, and taxation that the authors are not including to consider. Even many total market index funds are simply sets of securities that mimic the characteristics of the market. One may not have to own the 'market' to get its benefits."

It's also worth noting, says Padula, that research by John Campbell, a professor at Harvard University and a research associate at the National Bureau of Economic Research, as well as others, has found that volatility has increased and that more stocks are needed to achieve the same level of risk reduction that fewer stocks achieved in the past. "The risk definitions may be different, and one needs to be careful about transferring conclusions from one study to another," he says.

To be fair, the researchers noted that further studies are underway to investigate the validity of this small portfolio effect with respect to other risk and performance measures and in larger markets.

Bottom line: You should wait for further studies to prove fewer is better than more.

The current research "seems to suggest that fewer is better and that may not be the case when thinking about building a portfolio," says Padula. "It may work for their subset of assets using their definition of risk, but it doesn't tell the whole story."

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