In his book, You Can Be a Stock Market Genius
, Joel Greenblatt reviews a number of special situations that provide opportunities for significant profit potential. Mr. Greenblatt also tackles the question that every stock investor asks - how many stocks do I need to own to have a well diversified portfolio?
The objective of diversification is to reduce the portion of a portfolio's risk not attributable to the stock market's overall movements. Examples of this type of risk include when a product line doesn't sell well, a company cooks the books
, or a company misses earnings. Based on statistics, owning two stocks reduces this risk by 46%. Four stocks reduces nonmarket risk by 72%. Eight stocks cut your risk by 81%. Sixteen gives you 93% protection, 32 provides 96%, and 500 cuts your risk by 99%.
The result: Once you own eight stocks in different industries (and that part is key!), the benefit of adding more stocks in an effort to reduce nonmarket risk is minimal.
But what about reducing market risk? Adding other types of investments that have a low correlation to the stock market - REITs
, preferred shares
, royalty trusts
- can help you cut market risk.