Most investors are told that "diversification is the only free lunch." But this line is often misunderstood to simply mean "the more stocks you hold, the better."
Many believe this understanding of diversification is the key to achieving market-beating returns, but this simply isn't the case... Nor is it advisable.
Warren Buffett, arguably the most respected (and successful) investor in history, has been very clear about his views on diversification over the years.
Here's what he has to say about the matter:
-- "Wide diversification is only required when investors do not understand what they are doing"
-- "We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts."
--"If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice. It's the 'LeBron James' analogy. If you have LeBron James on your team, don't take him out of the game just to make room for someone else."
So what gives?
Here's the dirty little secret that Wall Street is not telling you about diversification: the more stocks you hold, the more likely you are to have less risk in your portfolio. That's it. Forget about beating the market.
The original research into diversification shows that as the number of holdings in a portfolio increases, the portfolio tends to act more like the broad market. You can see what I mean by looking at the chart below...
The chart above shows that as the number of holdings increases, the portfolio should provide the same level of risk as a broad market index. Risk is defined as how the portfolio should perform based on historical performance, also known as standard deviation of returns. And once an investor holds about 20 or more stocks, the portfolio's risk should be about the same as the market.
Think about it. Modern portfolio theory is very clear on this simple fact: generally speaking, the more stocks you hold, the more you ARE the market.
Now, there are some exceptions. And I am certainly not saying that the only way to outperform the market is by shouldering an absurd amount of risk.
My colleague Amy Calistri does a great job of talking about this idea in her newsletter, Stock of the Month. She has a maximum of 12 holdings at any given time in her newsletter.
Her reasoning? By focusing on a select few stocks at any given time, she's able to do a much deeper dive into her best ideas than most analysts. And after she buys the stock, she can watch her holdings like a hawk, and keep her readers apprised of any changes that may occur.
What I am saying is that if you're really looking to beat the market, you'll likely never do it with 20 or more holdings over a long time horizon. Instead, keep a tight portfolio that's focused on what you think are your best ideas.
This article was originally published on StreetAuthority.com: The Biggest Mistake Most Investors Make