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Should You Own 50 Stocks?

Tom Gardner receives dozens of questions each week about hisHidden Gemsinvesting philosophy, one that is soundly beating the market. Fellow Gems team member Rex Moore recently pulled together the most common questions for an interview with Tom.

This is the fifth of a five-part series. Other installments are linked in the box at the right of the page.

Rex: You have advice for your members about diversifying that goes against the thinking of some of your favorite master investors, like Buffett and Lynch. Why do you believe in broad diversification in equities?

Tom: For starters, Peter Lynch is a little different than Warren Buffett. Lynch did end up owning about 1,400 different companies in Fidelity Magellan. He was quoted as saying, "I can't find stocks that I don't like here" in the 1980s. I think Lynch did pay very close attention to valuation. And in any given year, there are loads of attractively priced stocks. You just have to patiently wait for great prices, and lately I think we're starting to get very attractive prices on select stocks for long-term investors in small companies. But Lynch's methodology was affected by how much money he had to manage. In counseling individual investors, he does suggest one to two dozen stocks.

Buffett obviously has talked about having a punch card of a limited number of investments; no more than say 15 in a lifetime. Clearly, that hasn't been the direction I have taken Hidden Gems. My approach on diversification is more like that of Walter and Edwin Schloss, who have generated unbelievable returns over the last half century. They've frequently owned more than 100 different stocks, and they're a small shop in terms of research. Now they are still concentrated because a large portion of their overall portfolio is in a fraction of those 100 to 150 stocks. And that's what is going to happen in Hidden Gems as well. I make 12 recommendations each year, and after a five-year period I may have 40 stocks going because of some repeat recommendations along the way. You are going to find that most of the value is captured by the top 15 names.

So, why do I like a diversified portfolio? First, I think it gives people an opportunity to learn about different industries. If a person becomes an expert on the business models of (Nasdaq: AMZN  ) , Gap (NYSE: GPS  ) , Johnson & Johnson (NYSE: JNJ  ) , and Dell (Nasdaq: DELL  ) , then suddenly she's got a great grasp of all these different industries and has automatically developed a better sense of the competitive advantages all great companies have in common, and as a result has become a better investor.

Second, a diversified portfolio spreads the risk. This is important particularly for relatively new investors who might get emotional about price volatility in the short term. The behavioral economists are showing how powerful the effects of greed and fear are in the marketplace. I think diversification helps take some of the emotion out of investing for investors in their first 10 years of buying stocks.

Third, I find that diversification compels investors to regularly add money and to not worry so much about where the overall market is. If investors focused their attention on their investment career, looking out more than 20 years from today, they'd stop fretting about the short-term fluctuations of the overall market. What is far, far more important are the principles of being a disciplined saver in your life and a perpetual investor.

Shelby Davis, the founder of the Davis Funds, which is a wonderful mutual fund family, said the best time to invest is when you have money to invest. It doesn't matter where the market is. The best time to invest is when you have cash that you can put away for three or more years. Davis started with $50,000 and turned it into $900 million over his lifetime. When he passed away, he held something on the order of 1,000 different stocks. Investors needn't be that diversified. But in Hidden Gems, I'll help members spread the risk in their early years as an investor. If 15 years in, you're beating the market soundly, devouring financial filings, and skilled at pinpointing competitive advantages alongside deeply attractive valuations, then I applaud the decision to concentrate a portfolio.

Rex: That philosophy ties in well with what you said earlier about 10-bagger magic. It turns a $10,000 investment into $100,000, offsetting those companies that may lose value for you. It would seem that if you haven't been buying quite a few small caps along the way, you are likely to miss the few multi-baggers.

Tom: That's a very good point, yes. The key with this Hidden Gems approach is to buy a broad collection of well-run companies at attractive valuations, then hold. Sure, you'll have a few long-term losers. But the benefits of holding that minority of investments that will rise five to 50 times over a decade will wash away your mistakes.

Of course, as you become more of an expert, you can concentrate your portfolio more. You can get a better sense and tilt things toward the few names that you feel best about. But for Hidden Gems and here at The Motley Fool -- and frankly across the country and around the world -- the majority of individual investors in stocks are still in learning mode. They haven't bought, held, and sold through dramatic bull and agonizing bear markets. Particularly in small caps, where price volatility can get very intense, diversification tempers the emotions. For investors in their first 10 years of owning stocks, an intensely concentrated portfolio is a mistake. I think the folks who advise it have not read the basic studies in behavioral economics, as I said. Greenhorn investors are very prone to the forces of greed and fear, letting emotion turn them into a stock trader rather than a business owner. That's not our game in Hidden Gems. We are looking for great businesses to own.

Rex: Tom, this has been an enlightening journey through your approach to small-cap investing and Hidden Gems. Thank you.

Tom: My pleasure. Thanks, Rex.

Are you interested in Hidden Gems? A no-risk,free trialgives you access to two selections each month, plus the complete Gems archives.

Tom Gardner owns shares of Johnson & Johnson. The Fool has a disclosure policy.

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