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How Diversified Should You Be?

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January 21, 2010 – Comments (10) | RELATED TICKERS: MTXX.DL

One of the most common questions received here at MagicDiligence is "how many stocks should comprise my portfolio?". This may, in fact, be one of the most common questions that individual investors around the world ask. Let's take a look at the reasons behind diversifying stock positions, investigate the answers and actions of some well-known investors, and then see what the Magic Formula Investing strategy has to say about the topic. In the process, hopefully we can come to a conclusion on a good number of stock positions to be sufficiently diversified (without over-doing it).

So, first, why diversify at all? The simple answer is to reduce risk. In investing, there are two basic categories of risk, which we will call "macro risk" and "micro risk". Macro risk are systematic concerns that can affect all stocks negatively. Examples of this would be recessions, military conflicts, inflation, high interest rates, and so forth. Micro risk, on the other hand, applies only to a single company or a number of related companies. For example, the FDA's loss-of-smell warning on Matrixx Initiatives' (MTXX) Zicam nasal products caused that stock to plummet 75%, but did not really affect any other stocks. These micro risks can also affect a handful of players in a particular industry or geographic area.

Holding a number of different stock positions cannot protect you against macro risk, but it can certainly help protect from micro risk. Going back to the MTXX example, if you were an employee there who held all of your 401(k) in company stock, your retirement nest egg would have been largely wiped out. On the other hand, if you had diversified evenly into just 2 stocks, the hit to MTXX would have brought your portfolio down "just" 38% (assuming a constant value for the other holding, of course). If you held a portfolio of 10 stocks, your total portfolio value would be down just 7.5%. Since no investor has a perfect crystal ball into the future, diversification is an important protection against micro risk.

But how much diversification is needed? 10 stocks? 30 stocks? 100 stocks or more? There are plenty of opinions on the subject. Too much diversification can limit return potential, as it is very difficult to pick a lot of big winners in the stock market. Two proponents of a concentrated portfolio are voices we should listen to. Warren Buffett, widely recognized as "The World's Best Investor", has repeatedly stated his opinion that knowledgeable investors should concentrate their investments in no more than 20 positions. Joel Greenblatt, the founder of Magic Formula Investing and manager at hedge fund Gotham Capital, has historically held less than 10 stocks. It has certainly worked well... Buffett has generated 20% annual returns for nearly 50 years and Greenblatt had an amazing 40% annual return run for 20 years at Gotham.

On the other hand, there are several examples of investment success through extensive stock holdings. Peter Lynch, the famous former fund manager at Fidelity Magellan, averaged a 29.2% annual return during his 13 year run, holding over a thousand individual stocks. Shelby Davis turned $50,000 into over $900 million by accumulating (and holding) over a thousand stocks during his 40+ years in investing.

Clearly, the gurus have succeeded with both concentrated and diluted diversification strategies. Let's see what mathematics has to say about the subject...

The most widely cited study on the matter is Edwin Elton and Martin Gruber's Modern Portfolio Theory and Investment Analysis . In it, they look at different levels of stock diversification and how much volatility is eliminated by owning more than one stock. While volatility is not the same thing as risk, it is often used as an academic shorthand and does offer some value to determining how drastic a portfolio can drop in value.

The study concluded that holding just 6 stocks reduced potential downside risk by 46% from holding just one stock. 10 stocks reduced it by 51%. 20 by 56%. After this the benefits leveled off. Holding 50 stocks reduces "risk" by 59%, and anything more than that by no more than 61%. By far the vast majority of micro risk was diversified away by holding as few as 6 stocks, and meaningful increases stopped at about 20 stocks. This 20 stock limit, promoted by no less than Warren Buffett, would seem to be the magic number of stocks.

Applying this to the Magic Formula Investing strategy, Greenblatt in The Little Book that Beats the Market advocates a portfolio of anywhere between 20-30 stocks, which seems to fall right around the "sweet spot" defined above.

There is one important thing to remember, however. The 20-30 stocks chosen should be spread out in different industry and geographic sectors. It makes no sense to hold a portfolio of 10 pharmaceutical stocks and 10 Chinese stocks. Industries can face particular challenges that affect all member companies, and particular geographies or countries can face political or natural disaster risks. Holding 20-30 stocks spread out amongst different industries and geographies adequately diversifies you against all of these concerns. The MagicDiligence Top Buys portfolio consists of bi-weekly Magic Formula stock picks, putting our position count at 26 high-quality, attractively priced stocks spread out amongst several industries and geographies.

10 Comments – Post Your Own

#1) On January 21, 2010 at 8:13 AM, lemoneater (78.14) wrote:

Helpful article. I have 28 stocks not counting WAMUQ which I keep to remind me of how quickly a stock can go down with bad fundamentals. My two biggest sectors are Medical: ISRG, MDT, ZMH, BABY for the main ones, and PHG, MMM, EMITF, and NHI for related stocks with exposure to the sector. And Materials: PCU, TRA, TNH, DD, and SWC. I think SE natural gas should also be in the list as a material although it is energy. I have also diversified with foreign picks. TTM, TSM, CEL, PSO and UL to name a few and multinationals like HNZ. I like variety, but I'm no Peter Lynch, so perhaps I should be content to hold less than 30:) 

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#2) On January 21, 2010 at 8:24 AM, devilzadvocate (49.06) wrote:

Interesting article! While I have 20 some shares in my RL portfolio, I do believe in Buffet's saying - "Wide diversification is only required when investors do not understand what they are doing".

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#3) On January 21, 2010 at 8:27 AM, lemoneater (78.14) wrote:

In that case, 1000 stocks here I come :) Have a great day!

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#4) On January 21, 2010 at 9:11 AM, catoismymotor (24.55) wrote:

For me spreading my cash over thirty companies would not be a good thing. Between work and family obligations I only have so much time to devote to investing. Until recently I held only six companies. I added a seventh, and absolute final, two weeks ago.

Amongst the seven I have companies in six different sectors across three countries. All are small or medium caps with low debt, good cash and decent to great moats. All are poised for growth.

St. Warren has professed the virtue of investing within your circle of knowledge. I think within that circle you need to know your limitations (mental, psychological, chronological and financial) before you take the plunge into the deep end of the investing pool.

 

 

 

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#5) On January 21, 2010 at 9:47 AM, lemoneater (78.14) wrote:

Good comment, Cato. We all have different proportions of time, responsibilities, experience, and money. Your limitations should determine your portifolio.

Except for busy season: late spring thru summer, time is an abundant resource for me. A lot of my job entails waiting. Stock research is one way to keep alert and sane. 

Also I should give credit where credit is due. I have what is in the nature of a brain trust. A lot of my stock picks come from suggestions from my husband who is interested in medical advances, although his field is electrical engineering, and from questions from my father-in-law who likes commodities and dividend stocks.

All the best on building a portifolio just right for your own situation. Know why you have what you have!

 

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#6) On January 21, 2010 at 11:17 AM, Melaschasm (55.51) wrote:

I use broad index funds for diversification.  I will own no more than a few small cap stocks, in an effort to boost my total return.

I expect to keep at least 80% of my stock money in index funds, and no more than 20% on individual stock picks.  I figure an occasional 10 bagger will boost my total return, while making some bad choices will not destroy my portfolio.

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#7) On January 21, 2010 at 12:56 PM, dsk315 (< 20) wrote:

I use a Defined Risk Strategy to limit risk.  It uses stock and options as an investment and another layer of options to trade.  The options are blended into the strategy in several ways and across multiple time horizons.  First, I use a LEAP to protect the core of my portfolio.  Essentially I guarantee myself a sales price.  Very helpful in 2008.  Then, I make several option trades throughout the year to generate income.  This income usually pays for the cost of the LEAP.  If the market goes down, I have pre-determined my sales price and when the market goes up, well, that's good too.

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#8) On January 23, 2010 at 11:22 AM, Varchild2008 (83.79) wrote:

I currently have 6 stocks...

And I am currently also of course...kinda obvious....invested in MTXX Post 75% plunge.   Those lucky enough to get into a stock AFTER the AFTERSHOCK can potentially set themselves up for big longterm gains.....  

As for employees with 401K in MTXX....  The Stock bottomed at $3.61 for now....and is now $4.49.  This is a  slow and steady recovery in share price.... The Recovery may be years away but by the time the 401K employee retires they will get back all they lost plus a nice profit.

It's not just about diversification.  It is also about holding during a plunge.....buying some more shares after the plunge to take advantage of the plunge.....so that when share price reaches parity with where it was before the plunge... you end up with a 75% profit off the NEWLY INVESTED MONEY and your old money has ZERO loss.

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#9) On January 23, 2010 at 11:23 AM, Varchild2008 (83.79) wrote:

Clarification:  Forgot to add that one of the biggest risks in the stock market happens to be getting into a stock after it takes a huge dive in share price..  So, one has to do their homework and lots of it.!!!

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#10) On June 25, 2013 at 12:28 AM, stevenrstark (< 20) wrote:

Getting in BEFORE the big dive is the biggest risk.

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