The Balancing Act of Portfolio Construction
When implementing the Magic Formula, one of the most common questions is: "How many stocks do I actually need to buy?" Buy too few, and one bankruptcy could wipe out your year. Buy too many, and you water down your returns, essentially turning your portfolio into an expensive index fund. Getting the number right is crucial for making the math work.
The Golden Rule: 20 to 30 Stocks
In his book, Joel Greenblatt is very specific: aim for a portfolio of 20 to 30 stocks. This is not a random guess — it is based on statistical probability.
The Magic Formula is not about picking individual winners; it's about buying a basket of stocks that, on average, will outperform the market. Because the formula buys out-of-favour, sometimes distressed companies, some of them will fail. Holding 30 stocks ensures that the 3 or 4 massive winners easily offset the 2 or 3 total losers. For an honest look at what can go wrong, read about the dark side of the Magic Formula.
What Happens If You Hold Fewer? (5 to 10 Stocks)
Some investors try to concentrate their portfolio to maximise returns, buying only the absolute top 5 stocks from the screener.
- The Risk: Extremely high volatility. If two of your top 5 stocks turn out to be value traps or go bankrupt, your portfolio will suffer massive losses that are hard to recover from.
- The Verdict: Too risky for a blind, mechanical strategy.
What Happens If You Hold More? (50+ Stocks)
On the other end of the spectrum, some investors buy the top 50 or 100 stocks on the list.
- The Risk: "Diworsification." By buying 100 stocks, your portfolio will start to mirror the returns of the broader market. Furthermore, rotating 50 to 100 stocks every year will result in massive broker fees and a logistical nightmare.
- The Verdict: Unnecessary and inefficient.
Risk vs. Reward Breakdown
| Number of Stocks | Diversification | Volatility | Management Effort | Recommendation |
|---|---|---|---|---|
| 1 – 10 | Very Low | Extreme | Very Low | Too Dangerous |
| 20 – 30 | Optimal | High | Medium | The Sweet Spot |
| 50+ | Very High | Market Average | Very High | Over-diversified |
Conclusion
Trust the math. Building a portfolio of 20 to 30 stocks provides the perfect mathematical balance. It is large enough to protect you from the inevitable individual bankruptcies, but concentrated enough to ensure that the Magic Formula's edge is not diluted into average market returns.
See how a 22-stock portfolio performed in practice in our 12-month Magic Formula experiment. Ready to build your own? Follow our step-by-step portfolio construction guide.
