The Limits of Diversification
A 1967 Federal Reserve study showed that, at that time, the typical individual stock portfolio held an average of 3.4 stocks. Advance a decade into the 1970s, and we find that the typical investment account had 10 or fewer individual holdings, with only 11% of investors holding more than 10 stocks. In the 1990s, highly respected mutual funds might hold 20–30 stocks and be considered “fully diversified.”
Today, looking into the funds of managers from around the world, we find that the typical active equity fund or separate account holds between 50 and 100 individual stocks, and a typical investor may have three, four, or more such active equity managers, adding up to hundreds, perhaps a thousand or more, of underlying public stock holdings. It is axiomatic: the higher the overall share of index constituents an investor or fund holds, the more those investments, in aggregate, will produce index-hugging returns, even though the goal of hiring active managers is to produce net outperformance over passive alternatives.
How did we reach these levels of diversification or, arguably, over-diversification? Many theories abound, but we will shortly present the three that, from our experience, were the main drivers.
We believe, and industry experience and academic research show, that there is a very defined upper bound to diversification, both in terms of its benefits in reducing the company-specific risk inherent in publicly traded stocks and in its ability to produce investment returns worth their cost of management.
Diversification is not simply a matter of adding more and more holdings and finding greater safety in those numbers alone.
Almost everyone understands that even prudence eventually has its limits in life’s pursuits, and you can, indeed, have too much of a good thing. Likewise, diversification is not simply a matter of adding more and more holdings and finding greater safety in those numbers alone.
We define “efficient diversification” as holding shares in companies across a sufficient spectrum of industry and country exposure so as to limit the failure of any single holding to a modest setback, but not so many stocks as to make the potential positive return contribution from any single holding negligible.
The math behind the theory has consistently shown that 95% of risk is alleviated at around 20–50 individual stock holdings.
A rapid review of the last 70 years of financial theory tells us that, since the advent of Harry Markowitz’s “Modern Portfolio Theory” in the early 1950s and its definition of risk as the volatility of share prices, the math behind the theory has consistently shown that 95% of risk is alleviated at around 20–50 individual stock holdings. The “sweet spot” varies from study to study, but the 20–50 range captures about 80% of the research on this topic over the past five decades.
The ability to reduce the risk of a complete wipeout through the addition of holdings based on mean-variance analysis has been shown to be effective in reducing individual enterprise risk in decades of peer-reviewed papers, starting with Evans and Archer’s seminal 1968 paper on diversification and dispersion, Solnik’s 1974 work on European equity portfolios, Tang’s 2004 study of international stocks, Irala and Patil’s 2007 paper on Indian portfolios, and, although not peer reviewed, Nomura’s 2016 “Stock Count and the Balance of Risk”. While each of the cited papers may disagree over the exact number of holdings needed to reduce 95% of all “unsystematic” or “idiosyncratic” risk in a portfolio, their suggested targets give us a range of between 20 and 50, far below the typical number of holdings in most funds and separately managed accounts.
Decades of research have pointed consistently to the same range. The forces that moved the industry so far beyond it are worth examining.
It is within this range of 20–50 holdings that the investor can achieve the largest reductions in individual stock risk while justifying the payment of active management fees, with a good chance of outperforming the less expensive and simpler passive alternatives. Thus, this range of holdings may be said to be “efficient,” hence our term “efficient diversification.” Decades of research have pointed consistently to the same range. The forces that moved the industry so far beyond it are worth examining.
How We Got Here
Forces much larger than peer-reviewed studies pushed the number of holdings in the typical portfolio beyond the mathematically optimal range over the past five decades. These were 1) significantly reduced trading costs, 2) affordable web-based trading and portfolio management systems, and 3) the consolidation of the active equity management industry.
First, before the deregulation of trading commissions in the United States (1975) and the United Kingdom (1985), commissions on stock trades ran upward of 5% of the value of the shares being purchased. Today, in almost all major developed markets, stock trades are either free or commissions range from 20 to 30 basis points, a drop of 94%. Free-to-negligible trading commissions will naturally encourage more trading and enable investors to own more securities. That was the very point of lowering such commissions.
Second, before widespread computing power, electronic ledgers, and the internet, the incremental cost of an additional security was much greater than today, both in terms of expenditure and administrative effort. Freed of those costs and tedious tasks, managers can easily manage 100 or more securities, even in a portfolio with 100% turnover per annum. And many now do. Though, as we’ve heard many times, just because we can do something doesn’t mean we should.
The “roll up” of independent asset management shops that began in the 1970s has increased the scale of assets under management at single firms.
The third major factor that drove the typical number of individual holdings higher over the past 50 years has been consolidation within the global active equity management industry. And that consolidation is ongoing. The “roll up” of independent asset management shops that began in the 1970s has increased the scale of assets under management at single firms. In 2025, the 20 largest asset managers on the planet controlled 47% of that total global pool (roughly $65.8 trillion), and within the top ten, the concentration is heavily skewed toward a few U.S. giants. BlackRock (managing about $14 trillion), Vanguard (about $12 trillion), and Fidelity Investments (about $7.1 trillion) collectively control roughly half of all fund assets in the United States.
Larger investment houses have a scale problem: it makes little sense for them to manage funds below $1 billion in their pursuit of economies of scale. As such, larger amounts under management require larger stock purchases and sales. For a fund with $20 billion in AUM and holding 40 positions (the upper limit of what we consider efficient diversification), that means an average position size of $500 million. Even for relatively liquid stocks, that is a large position to either build or dissolve. If, instead, the manager looks for 120 stocks in their portfolio, the scale of that effort shrinks to $166.7 million, a much more manageable task. The choice is either to increase the number of holdings or to close the fund at a lower AUM level.
Finding Our Way Back
Having identified the risks and pitfalls associated with over-diversification, are there steps that could move the needle on the number of holdings in actively managed portfolios back into the efficient and fee-justifying range?
The first step would be to consider whether over-diversification may be equally as harmful to the client’s best interests as is extreme concentration. Although the impact of under-diversification is generally more spectacular and notable than the subtler effects of redundancy, lack of efficacy, and additional fees associated with over-diversification, both deprive the investor of future income and gains. On the other hand, proving the costs of over-diversification requires proving a hypothetical: what would returns have been without the additional holdings? Yet this disparity in visibility should not cloud the seriousness of either extreme.
Step two would be to admit that many clients are simply not suited for actively managed equity portfolios, by virtue of either low risk and/or volatility tolerance, or a lack of resources and time to find a good match in the active equity manager community. Indexed investing is a wonderful way for investors to participate in global, sectorized, or localized growth in stock values. The prudent pursuit of alpha over passive alternatives is a legitimate fiduciary pursuit, but only for clients and their advisors sophisticated enough to demonstrate skill in picking active managers capable of justifying their fees. Such a pursuit in a 20-50 stock portfolio should naturally have guardrails to ensure that, even in limited numbers, risk is spread over several sectors and, in the case of regional or global portfolios, several countries.
In our own research, we consider ourselves analysts, historians, and futurists in our approach to understanding a company and industry.
The third suggested step would be to acknowledge that, while mean-variance stock price analyses are mathematically appealing and theoretically defensible, in isolation they have failed time and time again to create the safe havens that their proponents espouse when financial markets deflate. That said, price correlations and variances are useful as part of a larger analysis of a stock versus its peers or the opportunity set, but only by employing them in combination with real-world diversifiers such as the geographic spread of customers, suppliers, currencies, and raw materials, along with horizontal and vertical integration, liability and loss insurance, and the ability to hedge financial risk. This is exactly the type of value a properly vetted active equity manager is supposed to bring to the table: insights, efforts, and results that justify the active management fee. In our own research, we consider ourselves analysts, historians, and futurists in our approach to understanding a company and industry.
Lastly, the active managers themselves must be willing to cap their overall AUM for a particular fund at levels that prioritize clients’ interests over their own compensation. The allure of “just a little more” in AUM and revenue is almost irresistible in a world where asset gathering is highly competitive and long periods of drought may occur.
Efficient diversification is not a new idea. The evidence has been clear for decades. But committing to it requires all of us in active management to foster a trait that too few in our industry have embraced: restraint.
This article builds on research previously published by the author in 2014.
This communication contains the personal opinions, as of the date set forth herein, about the securities, investments and/or economic subjects discussed by Mr. Richey. No part of Mr. Richeys’s compensation was, is or will be related to any specific views contained in these materials. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. © Silvercrest Asset Management Group LLC
