Dear Analyst,

How many stocks is "too many"? I trade through foliofn. I can invest in up to 50 stocks, but I have 44 now. I'm about 40% large caps, 30% mid-caps, and 30% small caps so far. Plus, I've got some DRIPs in WMT, PG, FDX, BOBE, and AEE. I've been researching some small caps, and two of them look promising. I'd like to add them ... Am I dealing with too many stocks? I'm a long-termer, buy and hold. Please tell me, am I on the right track?

Tara's question really touches on three important issues of diversification: 1) how many stocks to own; 2) what percentage of the portfolio should be devoted to each stock type; and 3) how to use time when diversifying.

How Many Stocks to Own?
Diversification is a personal issue, and there is no rule of thumb regarding the number of stocks to hold in a portfolio. I know some investors who basically haven't held more than a handful of stocks at any point in time. I also know plenty who spend most of their investment efforts trying to make sure their portfolios own a piece of everything. I think many investors will agree that the number of stocks needed in a portfolio is really a function of an investor's knowledge of companies and ability to accept volatility.

The concept of diversification has been drilled into investors' heads for years and years. Thus, the very popular phrase "don't put all your eggs into one basket." It's also one of the most sacrosanct theories in academic finance. 

However, I think the concept has been oversold. Partly, the loss-limiting characteristics of diversification are extremely attractive to professional financial advisors who know that the magnitude of their clients' negative emotional reaction to losses is far more severe than the joys they get from gains. It's hard to earn a buck, and people hate to see their accounts decline in value, if only for a short period of time.

As I see it, the main problem with diversification is not that investors limit their gains, but that, in aggregate, they allocate way too many assets into investments that they don't know very well, and too few assets into investments for which they truly have a valuable understanding and insight.

For example, it's not uncommon to hear about employees splitting their 401(k) contributions 10 ways based solely on the fact that their retirement plan offered 10 mutual funds! Moreover, the typical mutual fund might own well over 100 stocks with the top ideas garnering only 2% to 3% of assets. By contrast, Warren Buffett built his phenomenal investment record by owning very few stocks and watching them like a hawk.

Investors also usually think of low volatility as being a valuable benefit of owning a large number of holdings. Did you ever think that this low volatility might merely be a favorable side effect from the cancellations of random price advances and declines, which tend to cover up the mediocre results from an investing strategy that's not centered on your best ideas?

In fact, the statistical studies I've seen indicate that, in terms of volatility, most benefits are reached by owning a dozen stocks (in different industries), and the marginal benefits from adding one more stock to the mix disappear somewhere around two dozen stocks. But that begs the question: Can anyone consistently generate 24 good stock ideas? Consider that at Morningstar we have an equity research department consisting of 40 analysts who cover more than 500 stocks. As I write this, only 16 stocks receive our highest stock rating of 5 stars.

Making Allocation Decisions
All stocks are not created equal. When deciding how much to allocate into a particular stock, it's important to consider the characteristics of the underlying company. Some companies have only one product line, are small, and have a large exposure to just a few customers. Because they're inherently riskier, these firms need to be balanced in a portfolio.

Other firms, however, have multiple product lines and a deep bench of management talent, and they profit off of a great number of customers. Because their businesses are already diversified, it's probably not unreasonable to allocate a larger percent of assets to these stocks.

For instance, on the surface,  International Flavors & Fragrances appears to be in the chemical industry. That's technically correct. However, the nature of the firm's business is tied to a myriad of clientele. IFF specializes in producing the artificial and natural flavor and fragrance ingredients we commonly see listed for products such as candy, processed food, fast food french fries and burgers, perfume and colognes.

With customers and products in different industries and around the globe, IFF stock already has a lot of built-in diversification. Consumer-product makers  Gillette ,  Colgate , and  Procter & Gamble also have non-cyclical businesses. Consumers will steadily keep buying razors, toothpaste, and soap.

On the other hand, companies such as heavy-equipment maker  Caterpillar and semiconductor-chip producer  Advanced Micro Devices ride through some pretty sharp business cycles. Cyclical stocks can have investment potential, but you'd want to pay careful attention to balancing the industries in your portfolio. Owning three or four heavy-machinery companies might protect against a company-specific event, but not one that's industry-wide. 

Cash Considerations  
Investors shouldn't be afraid of holding cash. There's a tendency to want to put cash into the market as soon as possible in order to reap the compounding benefits of being invested for a longer period of time. The problem is, if you happen to buy in at high prices, your returns suffer.

Instead of looking at cash as a drag on returns, Morningstar's equity strategist Mark Sellers likes to think of cash as an option to buy. Anyone who owns equities knows that stock prices bounce around a lot. Wouldn't you want to hold back some cash to take advantage of opportunities when stocks are cheap? You can't do that if you're fully invested.

I think you're better off holding some cash when you don't have solid investment ideas rather than spreading your assets over stocks that you don't know very well. The cash holding itself will dampen your portfolio's volatility, and you'll have an ace up your sleeve the next time you turn up a stock at a great price--frequently when the whole market, and all the stocks in your portfolio, have taken a nosedive. 

Acquiring Stocks over Time
Often it's not how many stocks you own, but how you acquired them that makes a big difference in portfolio performance. For example, let's say that after evaluating  Home Depot in August 2002, you reached the same conclusion our analyst did--that the stock was worth $36, and at a current price of $29, the shares were beginning to look interesting.

You could have plunked down $20,000 to buy the shares right then, but even if you were confident about the company's business, you still wouldn't have known how cheap the shares would get or how long it would take for the stock price to recover.

Instead of a lump sum, you could have bought the shares over time, say $5,000 worth every two months. You'd have bought at $29, $25, $21, and $24--buying more shares at lower prices and fewer shares at higher prices. The net result would have been a large stock position with an average price of $24.45, a few bucks below the original $29, to say nothing of today's quote of around $35. In the process of building the concentrated position, you limited pricing risks by spreading the purchase out over time at different levels. You also increased the profits from that stock idea by getting a better price. 

Not Bank Guaranteed
The diversification issue has several different angles, and there are more thorough discussions than this one. And, since I'm writing the article, I have the supreme luxury of picking examples that work out perfectly.

Making mistakes is an unavoidable part of stock-picking, and therefore you should always keep in mind what might happen to your portfolio if a big pick went sour. Still, I hope you'll agree with the virtues of limiting yourself to a few solid stock picks instead of buying lots of stocks you don't know very well.