You should certainly avoid starting a portfolio on day one with a dozen diversified stocks. It is almost certain that you will not be able to find that number of stocks on a single day that are offered at prices substantially lower than their values. Over long periods of time, some degree of diversification will probably occur, and it is not imprudent to maintain it as long as it does not impair your ability to concentrate on selecting new candidates or keeping up with what you already own.
An excessively diversified portfolio gives you a different version of the free rider problem. Just as a tax dodger benefits from a strong national defense without contributing to it, a bad stockenjoys the price you paid for it without contributing value to your portfolio.
Free riders are less noticeable in larger settings; it is easier to catch a tax cheat in Canada than in the United States, for example. Likewise, the more stocks you have in your portfolio, the less likely it is that you will catch and punish (sell) those which are free riding on your wealth and devouring it.
These principles of limited diversification hold only for wellchosen common stocks that carry a margin of safety between the price paid and the reasonable value estimated. For those, Buffett believes finding between 5 and 10 stocks would be sensible; Graham says between 10 and 30.
Graham and Buffett both emphasize that investors taking more aggressive stances, as professional money managers do, require the same kind of wide diversification casino houses adopt: The house needs, in Buffett’s words, “lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.
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