We have all heard about the mantra – “Don’t put all your eggs into one basket.” This sounds like good and reasonable advice, especially when the stock market is fraught with uncertainty and you are a risk averse guy.
But it is also an investment sin to spread yourself too thin. It is hard to enjoy dramatic success by being a Jack of all trades but master of none. Just ask yourself if you will engage a professional electrician to lay your house electrical services or an odd-job laborer who has “some part-time knowledge” of wiring? The answer is obvious.
In the business world, we can expect over-diversification to be a hindrance too. A conglomerate is usually too big, inefficient and spread out to focus effectively on core areas of competencies. Profits usually suffer from supporting the few rotten eggs.
Fact is, the more we diversify, the less we know (or have time to research) about a certain area. Many investors over diversify by purchasing an overwhelming portfolio of stocks.
They don’t realize that the best results are actually achieved through concentrating, by putting your eggs in a few baskets and guarding over them jealously.
At the onset of a major bear market, we are unable to react fast and liquidate our positions when we have too many stocks. A nimble investor would sell and sit on cash, while waiting to capitalize on other opportunities, rather than being bogged by existing losers. I will make some exceptions for blue-chip stocks which are still handing out juicy dividends though.
Over the years, I find it more useful to possess one or two big winners in my portfolio rather than 10-20 stocks which churn out pitiful profits. Over-diversification is a hedge for ignorance, not for spectacular profits.
Assuming you have only $20,000 to invest, I will say 4-5 stocks are about right, owning more is ridiculous. When a “diamond in the rough” comes along, examine your portfolio again and force yourself to liquidate at least one (or more) of the least attractive investments before adding another new stock.
The main idea is to keep things manageable. Would you rather spend hours tracking 20 stocks or be a smart investor, committing 15 minutes daily monitoring 4-5 carefully selected stocks but enjoying better profits?
I choose to work smart than work hard. What do you think?