Diversify or end up living in your moms basement...

Stock investors should diversify in order to smooth and eliminate unsystematic risk elements related to individual stocks. As long as you own stocks which are not perfectly correlated diversification will decrease your portfolio´s standard deviation while upholding the expected return.

My take is that investors that are not diversified are either cocky, stupid, Warren Buffet or gamblers. If you make the stand to not diversify you also make the stand that unexpected factors such as poor management (Volkswagen), accounting fraud (Enron) or crazy complexity (Lehman) will not unexpectedly haunt any of your few stocks.

Some examples:

• The cocky type: Knows the automobile industry well. As a Daimler engineer he invested all his money in Volkswagen and Daimler stocks at the end of 2009 as he expected above industry growth and solid margins for both solid german car companies. He is currently crying a lot  
• The stupid type: Worked as an Investment Banker at Lehman and reinvested all his earnings into the company as they had the best damn asset management business in the world. He is currently broke living in his moms basement
• Warren Buffet: The most successful investor in the world. He once stated "Diversification is protection against ignorance. It makes little sense if you know what you are doing". It is hard to argue with Warren Buffet, however there are numerous professional investors who have stepped into the role of the "cocky type". I´m just not willing to take the risk
• The gambler: This guy spent all his cash on stocks in a biotech company that is only a couple of clinical trials and studies away from curing cancer. He will most likely end up borrowing money to buy even more stocks in the given biotech company. The stock will soar until some clinical trial goes wrong and all his and his moms money evaporates. This guy will most likely use his moms credit card to buy a one-way ticket to Macau

According to the 2014 paper, "Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets," by Vitali Alexeev and Fransic Tapon the number of stocks needed on average to eliminate 90 % of diversifiable risk 90 % of the time is 55. This increases to 110 stocks in times of distress (for the US market). In other words, you should at least own 50 stocks or so if you are not Warren Buffet.

Risk decreases as the number of stocks in a portfolio increases:

                                      Source: Vitali Alexeev and Fransic Tapon paper 

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it.