One of the most common questions received here at MagicDiligence is "how many stocks should comprise my portfolio?". This may, in fact, be one of the most common questions that individual investors around the world ask. Let's take a look at the reasons behind diversifying stock positions, investigate the answers and actions of some well-known investors, and then see what the Magic Formula Investing strategy has to say about the topic. In the process, hopefully we can come to a conclusion on a good number of stock positions to be sufficiently diversified (without over-doing it).So, first, why diversify at all? The simple answer is to reduce risk. In investing, there are two basic categories of risk, which we will call "macro risk" and "micro risk". Macro risk are systematic concerns that can affect all stocks negatively. Examples of this would be recessions, military conflicts, inflation, high interest rates, and so forth. Micro risk, on the other hand, applies only to a single company or a number of related companies. For example, the FDA's loss-of-smell warning on Matrixx Initiatives' (MTXX
) Zicam nasal products caused that stock to plummet 75%, but did not really affect any other stocks. These micro risks can also affect a handful of players in a particular industry or geographic area.
Holding a number of different stock positions cannot protect you against macro risk, but it can certainly help protect from micro risk. Going back to the MTXX example, if you were an employee there who held all of your 401(k) in company stock, your retirement nest egg would have been largely wiped out. On the other hand, if you had diversified evenly into just 2 stocks, the hit to MTXX would have brought your portfolio down "just" 38% (assuming a constant value for the other holding, of course). If you held a portfolio of 10 stocks, your total portfolio value would be down just 7.5%. Since no investor has a perfect crystal ball into the future, diversification is an important protection against micro risk. Continue Reading »