What Is the Rule of 42? (2024)

Of course, there are many approaches to investing, and experts don’t necessarily agree on the optimal method of enhancing returns and managing risk. For example, some emphasize the importance of spreading your investments across industries and sectors, while others may prefer a certain number of different selections. The so-called Rule of 42 is one example of a philosophy that focuses on a large distribution of holdings, calling for a portfolio to include at least 42 choices while owning only a small amount of most of those choices.

Proponents of this approach posit that the old adage about not putting all your eggs in one basket is wise advice, which is why they suggest that an investor should have a wide array of investments, with most making up between two and three percent of their investment portfolio. By that formula, with at least 42 stocks at two percent of the holdings, that is 84 percent, leaving sixteen percent for weighting with some preferred investment options. The theory is that with that much variety, volatility with any small number of stocks won't have a significant adverse effect on the portfolio's overall performance. Further, this approach recommends careful distribution through different sectors and equity types to pursue even performance under changing market conditions.

The answer to whether any specific number of securities is the best depends on whom you ask. Some say that 30 is enough, including Liz Young, head of investment strategy at SoFi, who draws the line at a minimum of 20. But others look for much higher numbers, including one study by Roxbury Capital that concluded that anything less than 60 stocks was risky. The goal is to have enough distribution between market sectors that your components aren’t all subject to the same market forces.

Investment advisers typically suggest that a good approach, regardless of a specific number of elements, is creating a portfolio that contains uncorrelated assets. When the same external factors don't influence the price of two assets, they are uncorrelated. That way, the average volatility of each asset is lower than the volatility of the individual holding. Suppose each piece has minimal ability to affect the overall portfolio's value. In that case, the potential downside can be managed while the individual elements can enjoy their particular growth potential opportunity. A portfolio that includes a balance of stocks in various industries and across growth and size categories, supplemented by bonds, real estate, and other investment instruments, may be balanced without reaching a specific numeric count.