Value Investing and Diversification - How Much Do You Need?

20 stocks. 30 stocks. 200 stocks.... How much diversification do you need?

There is quite a difference between the portfolios of top investors. With all of the research out there on the probabilities of going bust, and on the effect of the number of companies in a portfolio, you would think that everybody would be adhering to some sort of value investing best practice.

The truth is much different though, and the answer to the question of how many stocks to hold when value investing is by no means black and white. While the statistics are more or less definite, people disagree on what the numbers mean for portfolio policy when value investing.

Graham: the Father of Value Investing

Years ago Benjamin Graham, the father of value investing, advocated that enterprising investors, investors who aimed to beat the market by investing in cheap net net stocks, should hold no less than 30 stocks in their portfolio. The reasoning was that an investor should chose a large number of stocks so that he can approximate the performance of net net stocks as a group.

The population returns of net net stocks are very good, especially when purchased for very cheap prices. By having a portfolio of more than 30 net net stocks, Graham was pushing investors to own a portfolio large enough to start approximating the net net stock population as a whole.

But anybody who has taken an introductory statistics class knows that a 30 unit sample only mirrors a population when value investing if that sample is made of randomly selected stocks. Probably to get around this issue, Graham would buy vast numbers of net net stocks -- he would hold hundreds of stocks in his portfolio at any given time when value investing.

Intuitively we know that the larger our sample of some universe is, the greater the similarity between our sample and the actual population. If an investor chose a portfolio with only two stocks then his portfolio would be far less likely to approximate the population returns than if he chose 100 stocks. When adding stocks to your value investing portfolio, at some point your portfolio becomes so large that it nearly makes up the stock universe itself.

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The conclusion investors can draw from this should be immediately obvious. If you only want to achieve the same returns as the net net stock universe as a whole then you should be trying to hold as many net net stocks as possible. But, of course, when value investing, I think there's a far better way to go.

The Effects of Quality When Value Investing

As you know, I use a quasi mechanical investment style when value investing. Essentially this means that I try to mirror the returns that a stub-set of the net net stock universe has. This ultimately means that there will be fewer stocks open to me to invest in, but so be it.

One major reason investors diversify their value investing portfolios is to eliminate non-market risk. Market risk is the risk to a portfolio that comes from investing in the stock market -- when something bad happens to your portfolio it is due to a market correction, stock price correction, or something similar. By contrast, non-market risk is risk that arises independent of the market. Typically this means risk directly linked to the business itself. Maybe the business has its factory burn down, or maybe the business loses a lot of money in the latest quarter. These sort of events can send a stock into a tailspin and hurt your value investing returns.

To protect against this, investors diversify. Graham's 200-300 stock portfolios would be well protected against non-market risk. Essentially, holding that many stocks would virtually guarantee that some part of his value investing portfolio would go bankrupt but, since he was aiming to mirror the results of the net net stock universe as a whole, the bankruptcy rate would also at most mirror the same rate seen in net net stocks as a whole.

Another way to protect yourself against non-market risk when value investing is to screen out companies that have a higher probability of going bust. Firms with a lot of debt, for example, are in a much more precarious position after the firm hits a major problem -- the debt these companies carry binds management's hands and can cause them to struggle to make debt payments.

Similarly, a company that depends on the credit markets can be much more risky since creditors may no longer lend to the company. It's these sort of characteristics that investors can screen out to help protect against non-market risk. Ultimately if companies with no debt have a 0.5% chance of going bust, then a small portfolio made of these companies would also be much less likely to face bankruptcy than a portfolio of debt-laden companies.

The Greenblatt Value Investing Advantage

Adding additional companies only helps eliminate non-market risk up until a point, as well. From Joel Greenblatt's book with the unfortunate title, "You Can Be a Stock Market Genius,"

Statistics say that owning two stocks eliminates 46% of the nonmarket risk of owning just one stock. This type of risk is supposed to be reduced by 72% with a four-stock portfolio, by 81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99 percent with 500 stocks.

It's pretty clear from this that diversification really starts to show diminishing results after a certain optimal number of stocks, and beyond that number an investor really has to weigh the available quality of further holdings against further reducing non-market risk.

In the End...

You can see why deciding on the proper level of diversification is not as black and white as it first appears. Choosing a diversification strategy really depends on the goals the investor has, his overall investment strategy. If an investor is happy with the returns available from the population of net net stocks as a group then he should opt to hold as many net net stock bargains as possible. On the other hand, if an investor wants to get the most of investing in net net stocks and feels comfortable with volatility (ie. if he has a strong stomach) then a smaller portfolio of well-selected net net stocks is the obvious answer.

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Article Author: Evan Bleker