Milton Friedman famously popularized the notion that there's no such thing as a free lunch. According to Harvard economics professor John Campbell, however, there's exactly one: diversification. Campbell writes:
Finance theory does offer a free lunch: the reduction in risk that is obtainable through diversification. An investor who spreads her wealth among many investments can reduce the volatility of her portfolio. ... There need be no reduction in average return and thus no bill for the lunch. [emphasis in original]
Which raises the questions: How many stocks do you own? How many should you own?
Eating your cake and having it, too
Diversification -- the practice of holding a wide variety of investments within a portfolio, spanning market caps, sectors, geographies, and styles -- reduces the overall volatility of your portfolio, thereby reducing the odds that you'll lose everything. And the events of the past two years demonstrate exactly how important reducing that volatility is.
When you're invested in only -- or largely -- one company, turns of events you never expected can out your investment in a matter of days. Liquidity dries up in the credit markets, and one of the world's largest investment banks is sold to another in a matter of days for pennies on the dollar. The economy hits the skids, and automakers riding the wave of SUV sales are suddenly flirting with bankruptcy. And before you know it, your portfolio is a whole lot leaner.
When you're diversified broadly, however, any given set of stocks taking a beating is likely to be balanced out by a group that's riding high -- or at least not getting beaten down as badly. Over the past year, for example, winery and distillery stocks are, as a group, down 23% while health information services stocks are up 97%.
It's that lack of correlation -- the fact that stocks don't all do exactly the same thing at the same time -- that allows diversification to reduce your risk. Even in a market as crazy as the one we've been living through, diversification can help cushion the wild swings.
In fact, according to Frank Armstrong III, an independent investment advisor writing in The CPA Journal, "In both theory and practice, the portfolio with the widest diversification will have the lowest risk. The ... optimum equity portfolio is the whole market. It's the one with the highest return per unit of risk. Anything less than the global portfolio is a bet against the efficient market and subjects an investor to uncompensated risk."
But Warren Buffett disagrees
Warren Buffett famously quipped that "Diversification is protection against ignorance. It makes very little sense for those who know what they're doing."
Although the market is largely efficient over the long term, it's more variable in the short term -- and that creates opportunities for the savvy investor. Academics frequently support indexing as a means to diversify, but the best investors know that over-diversification actually lowers returns.
Think about it: If the portion of the portfolio filled by any high-performing stock is extremely small, its overall effect will likely be negligible. A global portfolio will have returns that track the global market -- and no more. A portfolio concentrated in a smaller group of stocks, on the other hand, has the opportunity to outperform the market.
A concentrated strategy has paid off handsomely for Buffett and Berkshire Hathaway. In the 1970s, he invested $11 million in The Washington Post (NYSE: WPO ) , and that investment has turned into more than $1 billion. In the wake of Black Monday in the late 1980s, Buffett started buying Coca-Cola (NYSE: KO ) -- an investment that is currently worth more than $9 billion.
Buffett -- who may be the greatest investor of our time -- invests like this to this day. He's recently been buying Becton, Dickinson (NYSE: BDX ) and adding to his position in Johnson & Johnson (NYSE: JNJ ) .
The ability to create a concentrated portfolio, in fact, is an advantage the individual investor has over most professionals. As Peter Lynch, onetime head of Fidelity Magellan, argued, "The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile."
Lynch's big winners included Altria (NYSE: MO ) (when it was still called Philip Morris), Ford (NYSE: F ) , and General Electric (NYSE: GE ) -- but he's not against diversification. "It's best to own as many stocks as there are situations in which: (a) you've got an edge; and (b) you've uncovered an exciting prospect that passes all the tests of research," he writes in One Up on Wall Street.
That doesn't mean buying just to fill a niche: "There's no use diversifying into unknown companies just for the sake of diversity. A foolish diversity is the hobgoblin of small investors."
What about a Foolish diversity?
Tom Gardner, co-founder of The Motley Fool, believes in the "sweet spot where each position is large enough to make a difference if the stock takes off, but small enough that a 25% to 50% drop would not cause significant damage." That's the philosophy he uses to construct the real-money Motley Fool Million Dollar Portfolio.
So before you buy another stock, consider this: Will you still have that sweet spot between risk and reward? I'd argue that a portfolio of less than 10 stocks brings too much risk, while a portfolio of more than 30 stocks will likely dilute the reward. The sweet spot, then, is somewhere in between.
If you'd like more information about the Million Dollar Portfolio philosophy, or if you'd like to learn about our stock picks and optimal allocation for each new company, just click here to tell us where to send the info.
This article was originally published Aug. 21, 2008. It has been updated.
At the time of publication, Julie Clarenbach owned shares of Berkshire Hathaway, but no other companies mentioned here. Berkshire Hathaway and Coca-Cola are Motley Fool Inside Value recommendations. Berkshire Hathaway is also a Stock Advisor choice. Coca-Cola and Johnson & Johnson are Income Investor picks. The Motley Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy is concentrated goodness.