How Many Securities Should an Active Manager hold?

Many studies have disputed the widely accepted notion that a well-diversified portfolio of randomly chosen stocks must include at least 30 stocks. Furthermore, active managers generally do not select securities randomly, requiring a further examination of the notion to provide a more applicable portfolio construction framework. We find that an active manager’s conviction on the selected securities is a decreasing function of the number of securities held in a portfolio. Thus, a decision to determine the total numbers of portfolio holdings embodies an active risk budgeting exercise. We conclude that the active managers should establish a tracking error risk budget while considering the expected level of excess returns versus a benchmark using a target level of information ratio. Finally, based on the tracking error risk budget, active managers should then determine the number of securities needed in their portfolio.