In the world of investing, the phrase “don’t put all your eggs in one basket” is often considered gospel. But what if putting all your eggs in one basket—and watching that basket closely—isn’t as risky as it seems? Joel Greenblatt, a veteran investor and author, challenges conventional wisdom by suggesting that a more concentrated portfolio can be a smarter approach than spreading your investments thin across dozens or even hundreds of stocks.
Historically, the stock market has offered an average annual return of around 10%. Statistics show that in any given year, there’s about a two-thirds chance that your returns will fall within a wide range of -8% to +28%. This variability, known as standard deviation, remains roughly the same whether you hold 50 stocks or 500.
But what happens when you narrow your portfolio to just a handful of carefully selected stocks?
Surprisingly, the expected return remains the same at 10%, but the range of potential outcomes widens slightly. With only five stocks, you might expect annual returns between -11% and +31%, compared to the -8% to +28% range of a more diversified portfolio.
Greenblatt argues that this should embolden investors who prefer a more focused approach, especially if they have done their homework and identified high-conviction opportunities. The wider range of possible outcomes in a smaller portfolio does introduce more volatility, but it also allows for the possibility of outsized gains that could outpace the market averages.
A closer look at diversification reveals some intriguing statistics: Owning just two stocks can eliminate about 46% of the nonmarket risk inherent in holding a single stock. As the portfolio grows to four stocks, 72% of this specific risk is mitigated. With eight stocks, the reduction reaches 81%, and by the time an investor holds 16 stocks, approximately 93% of the nonmarket risk has been diversified away. However, beyond this point, the benefits of further diversification become marginal; owning 32 stocks reduces nonmarket risk by about 96%, and at 500 stocks, nearly 99% of this risk is eliminated. This data suggests that after acquiring six to eight stocks across different industries, the incremental risk reduction from adding more stocks diminishes substantially.
Over the long term, diversification across asset classes—beyond just stocks—can be more effective in managing risk than simply holding a large number of stocks. Most investors already have other assets, such as real estate, bonds, or cash, which naturally provide a level of diversification. In this context, adding dozens more stocks to a portfolio might dilute potential returns without offering substantial risk reduction.
For those looking to achieve above-average returns, Greenblatt suggests that a highly selective approach is key. Owning a few stocks that meet strict criteria can often yield better results than a bloated portfolio filled with mediocre choices. While traditional financial advisors may caution against concentrating your investments, Greenblatt’s strategy hinges on deep research and confidence in the chosen few.
The logic extends to the concept of "nonmarket risk," which refers to risks specific to individual companies, like a product failure or a regulatory setback. Research shows that after owning just six to eight stocks across different industries, the benefits of adding more stocks to reduce this type of risk become negligible. The major risk left to manage is "market risk," which is inherent to all stocks and cannot be diversified away.
Investing in broad index funds like the Total Stock Market Fund or the S&P 500 Index Fund may seem like a safe, diversified strategy, but it has significant drawbacks that can undermine your investment goals. Firstly, while these funds offer market-wide exposure, they also leave you entirely vulnerable to market downturns, with no built-in protection against losses. The attempts to hedge this risk through shorting or options are often counterproductive, merely resulting in a break-even strategy.
Index funds lack the reactive ability to take advantage of market inefficiencies; as stocks become overvalued, they gain more weight in the index, potentially skewing your portfolio when you might prefer to reduce exposure. Moreover, these funds offer no control over individual holdings, which means you’re stuck with every company in the index, regardless of your personal views or investment preferences. This lack of flexibility extends to investment strategies as well, as index funds cannot be tailored to incorporate specific tactics like value investing or growth stock selection, which could potentially offer better risk-adjusted returns. Finally, investing through an index fund can dampen personal satisfaction, removing the excitement and reward of making successful, well-researched stock picks, While index funds have their place, they may not be the best route for those immersed and passionate about the world of finance.
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