Joel Greenblatt – The Secret To Diversification Is Not Owning More Stocks

Joel Greenblatt – The Secret To Diversification Is Not Owning More Stocks

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.”

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

Here’s an excerpt from his book:

Peter Lynch: How Investors Can Find Their Edge

Peter LynchPeter Lynch was one of the best growth investors of all time. As the Magellan Fund manager at Fidelity Investments between 1977 and 1990, he averaged a 29.2% annual return. Q1 2021 hedge fund letters, conferences and more The fund manager's investment strategy was straightforward. He wanted to find growth companies and sit on them Read More

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

Previous article Top 15 Reasons Why Investors Have Missed The Bull Market
Next article DALBAR Responds To Edesess Article Published In Advisor Perspectives
The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates. It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization. The Acquirer’s Multiple® is calculated as follows: Enterprise Value / Operating Earnings* It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT. Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations. Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up. Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC. He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law. Articles written for Seeking Alpha are provided by the team of analysts at, home of The Acquirer's Multiple Deep Value Stock Screener. All metrics use trailing twelve month or most recent quarter data. * The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”

No posts to display