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How Diversified Should You Be?

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.

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