The Concentration Penalty

When we start investing, we are drilled with one golden rule above all others: Diversify.

It is the only "free lunch" in finance, they tell us. Don't look for the needle in the haystack; buy the haystack. Spread your risk. Never expose yourself to a single point of failure.

So, the diligent investor builds a portfolio. They buy a tech stock. Then a bank. Then a utility. Then, feeling "exposed," they add a pharma giant, a consumer staple, maybe a REIT. Before they know it, they own 45 stocks. They feel responsible. They feel safe.

But are they?

At YAIN, we believe that for the active stock picker, excessive diversification is not a shield; it is a sword that cuts both ways. It protects you from volatility, yes, but it also severs your connection to outperformance. It dilutes your best ideas with your mediocre ones.

Today, we are going to answer the oldest question in portfolio management: How many stocks are enough?

The answer lies at the uncomfortable intersection of Math (what reduces risk) and Psychology (what lets you sleep).

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Let’s start with the cold, hard numbers. Modern Portfolio Theory (MPT) distinguishes between two types of risk:

But how many stocks do you actually need to eliminate that second type of risk? The academic goalposts have shifted over time, creating confusion for retail investors.

The Classic View (10-15 Stocks): In 1968, researchers Evans & Archer published a landmark study showing that you could eliminate roughly 90% of unsystematic risk with just 10 to 15 stocks. For decades, this was the gospel. It validated the "focused portfolio" approach.

The Modern View (50+ Stocks): More recently, proponents of passive investing—most notably Burton Malkiel (author of A Random Walk Down Wall Street) and Campbell et al. (2001)—have argued that the world has changed. They found that individual stocks have become more volatile than they were in the 1960s. Their conclusion? To achieve that same level of safety today, you need 50 or more stocks.

The YAIN Reality: Malkiel is right if your goal is to perfectly mimic the index with zero deviation. If you want to be a passive vehicle, buy 50 stocks (or better yet, buy an ETF and go to the beach).

But as active investors, we are not trying to eliminate every ounce of volatility. We are trying to generate returns superior to the market. By holding 50 stocks, you are statistically guaranteed to reap the average result of those 50 companies. You have diversified away the risk, but you have also diversified away the Alpha.

Once you hold 12 to 18 uncorrelated stocks, you have hit the point of diminishing returns. Adding a 19th stock reduces your risk profile by a fraction of a percent, but it actively dilutes the impact of your best ideas.

Peter Lynch, the legendary manager of the Magellan Fund, coined the term "Diworsification."

It happens when you add an investment to your portfolio not because it is a great opportunity, but because you feel you "should" own something in that sector, or simply to lower your concentration.

Think about it logically. You spend weeks researching your #1 Idea. You know the management, the margins, the moat. You have high conviction. You do real work on Ideas #2 through #10 as well.

But what about your #35 Idea? Do you know it as well as #1? Is the potential return as high? Likely not. By moving capital from Idea #1 to Idea #35 in the name of "safety," you are actively moving money from your highest conviction asset to your lowest conviction asset.

You are selling the winner to buy the mediocre.

As Charlie Munger famously said:

"I can't imagine a group of people more diluted than those who have 50 or 70 positions. If you have 3 or 4 businesses that you understand and they are dominant, why would you want to put money in your 20th best idea?"

For the individual investor (that’s us), we don't have the constraints of a Mutual Fund. We don't have to own the market. We have the luxury of saying "No."

There is a cognitive constraint to diversification that models ignore: Attention.

You can only truly "know" a limited number of companies. To be a YAIN-style "Quality Owner," you need to:

How many companies can you do this for while having a full-time job and a life? Is it 50? Impossible. Is it 30? unlikely. Is it 10-15? Yes.

When you own 50 stocks, you stop being an investor and start being a collector. You stop reading the reports. You rely on headlines. When a stock drops 15%, you don't know if it's a buying opportunity or a thesis break, because you haven't done the work. Ignorance is a risk factor that diversification cannot fix.

So, what is the optimal number?

For the dedicated fundamental investor, we believe the sweet spot is 10 to 20 stocks.

Here is why this range works:

With 10-20 stocks, your average position size is between 5% and 10%.

This offers the perfect balance: Enough concentration to generate Alpha, enough diversification to survive a disaster.

Following 15 companies is manageable. You can read every earnings transcript. You can actually understand what you own. This depth of knowledge provides psychological armor during bear markets, preventing you from panic-selling.

With 15 slots, you can easily cover the major drivers of the economy without overlapping.

You are diversified by business model, not just by ticker count.

The "right" number ultimately depends on your goal. Are you trying to Get Rich or Stay Rich?

Strategy: Concentration. Number of Stocks: 5 to 10. If you have a smaller portfolio and a long time horizon, you need meaningful compounding. You need your winners to move the needle. You accept higher volatility for higher potential returns.

Strategy: Diversification. Number of Stocks: 20 to 30 (or ETFs). If you have already won the game, stop playing so hard. Your goal is to not lose purchasing power.

Warren Buffett famously told students that they would be better investors if they were given a punch card with only 20 slots for their entire lifetime. Every time they bought a stock, they punched a hole. When the 20 slots were gone, they could never buy another stock.

This thought experiment forces extreme patience and extreme conviction.

If you knew you could only buy 20 stocks in your life, would you have bought that speculative EV SPAC in 2021? Would you have chased that "turnaround" story that never turned around?

Probably not. You would have waited for the fat pitch—the LVMH, the Microsoft, the Schneider Electric.

You don't need a lifetime punch card, but try a Portfolio Punch Card:

This "One-In-One-Out" rule is the most powerful discipline tool you can use. It forces you to compare the new idea against your current roster. "Is this new idea better than my worst current idea?" If the answer is no, you don't buy. Simple as that.

Investing is one of the few fields where working harder (buying more stocks, trading more often) often leads to worse results.

Complexity is the enemy of execution. A portfolio of 40 stocks is a garden full of weeds. You can't water the flowers because you are too busy trying to identify what is growing in the corner.

Prune your portfolio. Look at your holdings today.

If they are not compounding, cut them. Reallocate that capital to your top 5 ideas—the ones you actually believe in.

Don't aim for a portfolio that looks like a mutual fund. Aim for a portfolio that looks like a collection of businesses you would be proud to own for ten years.

12 to 18. That’s enough.