How Many Stocks Should an Investor Own?
An analysis of diversification vs concentration in investing.
10 minutes
We have all heard that one should diversify their investments. That one should not place all their eggs in one basket.
While I find these common sense sayings to be true, I also believe they are frequently exaggerated and taken to the extreme by Wall Street.
To mitigate market risk and produce a fate-ending mistake, institutional investors have accepted the notion of diversifying for its own sake. To me, this seems incorrect, as it requires you to invest capital in your Nth idea, instead of investing more in your best ones.
To illustrate, here is a quote from John Mayer Keynes: “To suppose that safety-first consists in having a small gamble in a large number of different companies where I have no information to reach a good judgment, as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment policy.”
So, when and how does diversification make sense?
Market Risk
First, let’s look at diversification and its use to mitigate market risk.
Diversification addresses a small portion of the overall risk of investing in the stock market called market risk.
This risk refers to your holdings going down in value from general movements in the market.
I believe diversification is of little help to reduce this risk because even if you took the precaution of owning 500 stocks, you would still be at risk for the up-and-down movement of the entire market.
Non-Market Risk
Secondly, let’s analyze how diversification can help an investor reduce non-market risk.
The risk associated with the results of an individual investment, that is not related to the stock market’s overall movements, is called non-market risk.
This type of risk can arise when a company’s factory burns down, when a new product doesn’t sell as well as expected, or when a company goes bankrupt.
Thus, diversification can help an investor avoid catastrophic mistakes from individual investments.
How Many Stocks Should You Own?
Based on the above, diversification can, for the most part, help investors mitigate non-market risk.
So, how should an investor diversify?
According to Joel Greenblatt, statistics say that owning just two stocks eliminates 46 percent of the nonmarket risk of owning just one stock. This type of risk is supposedly reduced by 72 percent with a four-stock portfolio and by 81 percent with eight stocks.
Summary
After purchasing six or eight stocks in different industries, the benefit of adding even more stocks to your portfolio to decrease risk is small.
Overall market risk will not be eliminated merely by adding more stocks to your portfolio.
Contrary to popular opinion, diversification for its own sake might hurt your returns because you can end up investing in less attractive opportunities.
In the end, I believe the best strategy for an investor is to own a small number of undervalued companies, with simple businesses, that you truly understand.
Monhish Pabrai, for example, likes to make investments of 10% of the value of his portfolio. This strategy can be optimal, as it reduces non-market risk by > 80% based on Joel Greenblatt’s analysis.