A Stock Investing Conundrum: What's the Right Diversification Level?

It's not easy to pick winning stocks, but as The Motley Fool's various services prove year in and year out, it's certainly not impossible. With the right mind-set and some careful research, an individual investor with a long-term, buy-and-hold mentality can craft a portfolio that will outperform the market. But just how many stocks should be in such a portfolio? One guideline that we devised is the Gardner-Kretzmann Continuum, which is simply the ratio of the number of stocks in your portfolio to your age. For example, if you own shares of 30 different companies, and you're 24, your score on the G-K C is 30/24= 1.25. We think a good level to shoot for is a number above 1. But that's not the only way to go.

In this mailbag segment from the Rule Breaker Investing podcast, a listener is looking for insights about the upsides of greater diversification, and alternately, the positives of holding somewhat fewer companies. Motley Fool co-founder David Gardner and Head of Motley Fool Asia David Kretzmann reflect on the pros and cons of various approaches.

A full transcript follows the video.

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This video was recorded on March 27, 2019.

David Gardner: Now, to the question at hand, David Kretzmann. Paul writes, "I had a question about the Gardner-Kretzmann Continuum. I'm 38 years old with a G-K C score of around 0.7. If anything, I would like to make it lower. I had read in the past that individual investors tend to perform best when they stick with their highest-conviction ideas. Expanding beyond that tends to dilute performance. That makes sense to me, and it's why I've always tried to stick to between 20-30 companies. That also seems to go with the Rule Breaker philosophy to me. Why would I want to invest in my 31st best idea when I could just add more to my two or three best ideas? Can you tell me where I might be wrong, why more positions are better? Thanks again for all that you do. Fool on, Paul."

David Kretzmann: Awesome question! I think it's something that we repeat a lot of times on this podcast and other podcasts: your mileage will vary depending on your own situation, your own preferences, risk tolerance. There's not necessarily anything wrong with having a G-K C score below 1, which Paul in this case has. I think most individual investors should shoot for a G-K C score of about 1, just to be thinking in terms of broad diversification within your individual portfolio.

Gardner: Let me pause you right there, David, because I know we have some new listeners since we last talked about the G-K C, which we seem to do every month or two on this podcast. Could you briefly define our term, the Gardner-Kretzmann Continuum? What does 0.7 mean?

Kretzmann: Sure. The Gardner-Kretzmann Continuum, it's probably lapping its one-year anniversary at this point, if I'm not mistaken.

Gardner: I've heard rumors that it's being considered for the Nobel Prize in Economics.

Kretzmann: Oh, excellent!

Gardner: It puts Gardner and Kretzmann in a position -- I'm not going to say a pole position, but potentially, to win the big bling, that hunk of metal that I always imagine the Nobel Prize must be. Obviously, modesty can sometimes escape us. David, what is the Gardner-Kretzmann Continuum?

Kretzmann: This is a simple score. You take the number of stocks that you own in your portfolio and you divide it by your age. As an example, let's say you own 50 stocks and you're 25 years old. Your G-K C score is calculated by dividing the number of stocks that you own -- in this example, 50 stocks -- divided by your age -- 25 years old. So in this case, your G-K C score would be 2.

Gardner: Well above one. That's remarkable! You have a lot of stocks, given your age.

Kretzmann: A lot of diversification for your age. If you're 50 years old and own 50 stocks, your G-K C score is 1. Generally on this podcast, over the past year or so, as our G-K C score has evolved, David, you and I have thought that you don't need to aim for just 1. But ideally, 1 or higher.

Gardner: 1.0 is kind of the golden mean. A way of thinking about it is, if you're 25 years old, maybe you should have 25 stocks. I'm 52, I have about 52 stocks. There's no one way to go here. That's why it's called the Gardner-Kretzmann "Continuum."

Kretzmann: Some people will be below 1 and they'll be perfectly comfortable with that.

Gardner: Like Paul!

Kretzmann: To Paul's point, the question of, is it OK to shoot for 20 to 25 stocks, there's the Warren Buffett adage or quote that's out there, he says you should really treat buying stocks like you're punching a card where you only have 20 boxes to punch or check. Essentially meaning that over the course of your life, invest as if you're only going to buy 20 companies. I think the meaning behind that quote is to really focus on buying quality, great businesses that you want to own for a lifetime, which is something we aspire to do as Fools.

On the flip side, in our recommendation services like Stock Advisor or Rule Breakers -- or really, since The Motley Fool launched with you and Tom over 25 years ago -- the focus has really been to continue following and recommending stocks week by week, month by month, really trying to continually explore the world of business out there and try to find all the quality businesses out there. I think now in Stock Advisor and Rule Breakers, we've probably recommended over 300 companies over the past two decades or so.

Gardner: Many of which remain active recommendations. But yeah. In my experience, David, now in our third decade of The Motley Fool, and having been there at the very start, having met so many individual investors of all stripes in many different countries -- David, you're now head of Motley Fool Asia, so you especially know that better than I -- in my experience anyway, the mistake most people make is they are not diversified enough. They do not have enough stocks. So it makes me far happier to see somebody with a lot of stocks than with just a few stocks.

Paul, I think 0.7 is just fine. You sound like a savvier guy at the age of 38. You've got less than 38 stocks. If that's working for you, that's great. If you want to keep adding your winners, we like that too.

Kretzmann: Yeah, absolutely! This is all directional more than anything, trying to think in terms of more diversification, not less, especially for beginners. I think a common mistake is to only buy one or two or three stocks. That way, you're just so emotionally invested in those companies. You're more likely to follow short-term movements in that case and potentially get spooked out of the market or just get the wrong idea that, "Hey, one of my stocks jumped 30% this month! I'm really good at this! I'll just keep doing this! Rinse and repeat."

I think one of the benefits also of owning more stocks is, it encourages you to pay attention to the world maybe a little bit more closely. Your portfolio doesn't get stagnant. Even if the new stocks you're adding represent less than 1% of your portfolio, you have a little bit of skin in the game. You can follow along. Especially with the year like this. You have a lot of new companies coming public. You have Lyft, Zoom, Uber, a bunch of different companies --

Gardner: Pinterest.

Kretzmann: -- Airbnb, hitting the public markets. Having skin in the game, I think, encourages you to follow along like an owner. And it can make it a little bit more fun.

Gardner: Absolutely! So, again, thank you, Paul, for a great question! There is no one-size-fits-all. That is why it's the Gardner-Kretzmann Continuum. We of course have fun with that, but we're deadly serious about the point. Each of us should be maintaining a well-diversified portfolio. That phrase can mean different things for different people at different stages of their life.

David Gardner has no position in any of the stocks mentioned. David Kretzmann has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.