76 ATaleofTwoMarkets
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 stoc kenjoys 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. Like-
wise, 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 well-
chosen 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 man-
agers 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.”^6
Asset Allocation
Excessive stoc kdiversification (and portfolio rebalancing, as dis-
cussed in the last chapter) should be distinguished from a more
fundamental and important investment principle called asset allo-
cation. This principle recognizes the many types of assets available
to investors, not just common stocks. Alternatives include bonds,
cash, real estate, real estate investment trusts (REITs), and com-
modities. These alternatives often furnish attractive ways to store
and build wealth. Their relative attractiveness is potentially greatest
when stoc kmar kets do not appear to offer prices lower than values,
a prudent time to consider investing in these asset classes. Alter-
natives also include any mix of these asset classes invested in tax-
advantaged vehicles such as individual retirement accounts (IRAs)
and 401(k) plans.
Most investors tend to end up with a diversified mix of these
different asset classes: home ownership, some cash on hand, a re-
tirement vehicle, and a stoc kand bond mix. Those who do not
should try to do so. Diversity across asset classes is important as a