One of the biggest questions facing most investors is how may stocks to hold to provide the appropriate level of diversification. Answers vary with some of the greatest investors preferring to make large bets on fewer stocks while others prefer to own dozens of stocks. One answer can be found in the book – You Can Be A Stock Market Genius, by Joel Greenblatt who prefers to take a different view saying, “Leaving some of your assets on the sidelines (i.e., out of the stock market) should be your compromise to prudent diversification.”

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Joel Greenblatt

Here’s an excerpt from his book:

For about $1,000, an insurance company will agree to pay a healthy thirty-five-year-old male $1,000,000 should he be unfortunate enough to die over the next year. The actuarial tables say this is a good bet for the insurance company. But would you take the insurance company’s side of the bet?

Probably not. The reason is that regardless of what the statistics may indicate, you can’t afford to lose $1,000,000— especially for a crummy thousand bucks. The insurance company, on the other hand, by pooling thousands of policyholders together can create a portfolio of underwritten risks that do follow the statistical tables. That’s why they can make a good business out of consistently booking bets that you, as an individual, can’t afford to take.

In effect, a specific risk, when viewed in isolation, may appear unsafe or even foolish, but in the context of an entire portfolio, the same risk can make good sense. So, if that’s true and spreading your risks around is such a good idea, why do I keep telling you that owning just a few stocks is the way to go?

The answer comes in two parts. First, on each individual policy, the insurance company was risking a loss of $1,000 for every $1 bet. It would take many thousands of similar policies over a period of years to make this bet worthwhile.

Fortunately, the risks you assume by purchasing individual stocks are limited to a $1 loss for each $1 invested. As a result, you can prudently invest in only a handful of attractive stocks without being accused of taking crazy risks. But everyone else advises maintaining a widely diversified portfolio; how can you be expected to “go for it” by focusing on only a few selected stock-market opportunities?

The answer, and the other reason why a widely diversified stock portfolio isn’t a magic formula for avoiding risk, can be found in the way you should be thinking about your stock investments from the start. It’s important to remember that for many people a stock portfolio is only a portion of their entire investment holdings. Most people have a portion of their net worth in the bank or in money-market funds, in their homes, in bonds, in the value of their life-insurance policies, or in investment real estate, to name a few likely places. If you’re looking to avoid putting all your eggs in one basket, this broader type of diversification, over varying asset classes, will accomplish that goal more effectively than merely diversifying your stock portfolio. In other words, don’t screw up a perfectly good stock-market strategy by diversifying your way into mediocre returns.

In fact, no matter how many different stocks you buy, investing in the stock market with money that you will need over the next two or three years to help with rent or mortgage payments, food, medical care, tuition, or other necessities is risky in the first place. Remember, the potential swings in stock-market returns from year to year are huge anyway, even if you diversify to the extent of owning all 8,000+ stocks. Rest assured, the practice of selling stocks when you need the money holds little promise as an effective investment method.

Ideally, your decisions to buy and sell stocks should be based solely on the investment merits. This may mean leaving that extra money in the bank or in other assets, even if you’ve made up your mind that stocks are the investment vehicle of choice. Leaving some of your assets on the sidelines (i.e., out of the stock market) should be your compromise to prudent diversification. As long as you’re willing to do your own homework, a strategy of owning a select handful of your favorite stock situations should yield results far superior to a strategy of owning dozens of different stocks or mutual funds.

From time to time, this selective strategy may result in slightly wider swings in performance than a strategy based on owning a few shares of everything, or what’s known as an indexing approach. However, if you have arranged your overall portfolio of assets so that you can weather the inevitable market downswings without being forced to sell, this slight difference shouldn’t matter. What should matter is that over a period of even five or ten years, you can have your cake and eat it, too. During those years, you will have invested in dozens of different investment situations (although in only a handful at any one time), thereby getting plenty of diversification with superior returns to boot.

Article by Johnny Hopkins, The Acquirer's Multiple