FOMO and diversification
Written by: Dr Isaac Kean – Market Insights, Tatton Investment Management
Most investors know that diversification is a virtue. Individual stocks or bonds can suffer for any number of reasons that are near impossible to predict without perfect information about each asset. Diversifying by holding lots of different assets your returns should be guarded against these idiosyncratic risks. The winners and losers should balance out, allowing investors to benefit from broad trends in growth.
But how much stock diversification is enough? The current rule of thumb is that 30-40 individual holding is enough and this has been accepted since the 1980s, following a paper by behavioural investing pioneer Meir Statman. Conventional wisdom has worked well for many investors, but it’s also gone badly, so is it right?
Key Points
- 30-40 individual holding is enough has been accepted since the 1980s
- Adding more stocks significantly reduces idiosyncratic risk until at least the 100 mark
- Less than 5% of stocks account for the extra return that equities display compared to bonds
- Active management means taking on extra idiosyncratic risk
- Diversification may be a virtue, but should not dilute opportunity
Concentration leads to FOMO
Last year researchers at Erasmus University in Rotterdam simulated stock portfolio performance using data from 1985 to 2023, with random stock sampling according to various rules for portfolio construction*. They worked out that, for a global stock portfolio, adding more stocks significantly reduces idiosyncratic risk until at least the 100 mark (and this only becomes negligible at an impractical 750 stocks). In other words, the right amount of diversification is above 100 and well above the 30-40 range that many fund managers still use.
One of the key reasons investors need more diversification is that stock market returns are so highly concentrated on a small number of winners.
Previous studies** which show that most stocks underperform government bond returns. Looking at both global and US stock markets from 1926 to 2016, less than 5% of stocks account for the extra return that equities display compared to bonds. During this same period, it was Exxon Mobile, Apple, Microsoft, General Electric and IBM which generated 10% of total wealth creation on the U.S. stock market. The “Magnificent 7” (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, Tesla) has shown a similar outcome over the past decade.
So, if you have a small number of stocks in your portfolio, you are more likely to miss out on those winners – the FOMO risk. Anyone who avoided the Magnificent Seven US tech stocks in recent years will have felt that FOMO.
Who’d be a stock picker?
Research is fine, but it’s very different from making real decisions with someone else’s money. A crucial caveat to these findings is its use of random sampling of stocks (within some defined portfolio rules) and of course, the whole point of an active investment manager is that they should be better than that. In fact, much better, since beating average market returns is how they justify their pay.
Which of course is a benefit of stock picking; investors can easily see whether or not the manager is skilled at weeding out idiosyncratic risks and not just buying the market.
We are agnostic over whether active or passive is best for your clients, but its fair to say active investment managers have had a tough time in recent years – largely because simply following the big names has been a winning strategy.
Stock-pickers tend to avoid the largest stocks, as those stocks tend to have the most stretched price-to-earnings valuations. But, in the last decade or so, the US mega-cap stocks have been able to leverage their immense size to keep dominating their respective industries and rapidly growing profits.
That being said, the biggest US tech stocks underperformed the rest of the world last year – and this underperformance has continued into 2026. The recent dispersion in global stock market performance and in particular the recent sectoral impact of AI could see active investment managers come back into adviser thinking, despite some addition cost.
You can’t have your cake and eat it
There are many good reasons to select active investment, and we have argued before that the growth of passive investment has distorted asset markets overall. Active management means taking on extra idiosyncratic risk, but with sectoral volatility that could well pay off.
The point is that an investor should be aware of any extra risks they are taking on, and investment managers should always be upfront about what those risks are. The problem with the idea that ’30-40 stocks is enough’ is that it obscures risks, making investors feel like they can have their cake and eat it too.
The best stock pickers are, naturally, very rare, so our selection focus, like our own investment philosophy, is consistency in returns and strategy.
Since we are fund selectors, our diversification process has a focus on risk contribution to prevent inadvertent risk duplication across active funds. We want to guard wealth over the long-term, not be influenced by FOMO and so understanding risk overlap across strategies is fundamental. This allows us to let managers run alongside each other in a risk balanced portfolio. Diversification may be a virtue, but should not dilute opportunity.