How Many Stocks Should You Own?

With this year's rough ride, you don't need reminding that stocks are volatile.

Their prices bounce up and down, sometimes in extreme ways. The U.S. market as a whole has produced average annual returns of about 10% over the past century, but it doesn't go up 10% every year. In roughly one out of four years, it declines-sometimes a lot.

If stocks returned the same amount every year, then, like bonds, they would yield gains of only a few percentage points. High returns are the reward you get for enduring the fear (often the sheer terror) of watching pieces of your nest egg disappear into thin air. People like me tell you to hold on. History shows that markets bounce back. But enduring sickening declines isn't easy.

The best way to smooth the ride is through diversification. I'm not talking here about portfolio diversification-the allocation of your assets to stocks, bonds, cash and maybe more. Portfolio diversification is a necessity but a subject for another day. The topic today is diversification in the part of your portfolio that consists of stocks and stock funds.

The value of diversification seems awfully obvious. Morningstar data in June 2021 showed that about 39% of all U.S. stocks had ever suffered three-month losses of 50% or more, but fewer than 1% of diversified stock funds had incurred losses that severe.

Consider the sad tale of Enron, once a high-flying Houston energy company. When it collapsed in 2001, thousands of investors, including Enron employees whose retirement plans were heavily invested in the stock, suffered huge losses. Enron was the seventh-largest company in the Fortune 500, but in 2000 its market capitalization (price times shares outstanding) represented less than 1% of the value of the S&P 500 index. If you had put $10,000 in an S&P 500 index fund and all the other stocks maintained their prices, then Enron's trip to zero would have cost you just $100.