I have a confession to make. My name is Rich, and I'm a stupid investor.
You see, I'm a Freddie Mac shareholder. I also own a small stake in Fannie Mae. But that's not what makes me a stupid investor.
These men are not stupid
Plenty of great investors held shares of the government-sponsored enterprises, including Bill Miller, Rich Pzena, Jean-Marie Eveillard, and David Dreman.
None of these men are remotely stupid. In fact, they are among the most accomplished investors of this generation. But there's a key difference between those men and me.
OK, two key differences
For starters, each member of the aforementioned foursome is a far more experienced investor than I am. And that likely goes a long way toward explaining the second key difference between us.
My exposure to Freddie and Fannie was much greater than theirs.
Watching any of your holdings plummet by 90% is painful. But that pain increases exponentially when the sinking stock comprises a significant portion of your portfolio.
In my case, Freddie Mac was my largest individual holding -- by a long shot. My failure to practice proper diversification has likely postponed my retirement by a number of years.
Good thing I love my job
I'm not going to lie: My paper losses sting pretty badly right now. But I believe the lesson I learned from this experience will make me a much stronger investor -- and may actually wind up saving me money down the road.
I've learned that it doesn't matter how confident you are in any single company's prospects, or how great you believe your margin of safety to be. In investing, there is always a chance that your company's stock can drop precipitously. If you don't take pains to protect your portfolio against this possibility, you're placing your hard-earned assets at risk.
Take Rich Pzena, for example. Freddie Mac was his largest holding, too. But because Pzena owns a broad portfolio containing more than 100 names, Freddie comprised less than 5% of his total assets.
He'd already had a rough go of it so far in 2008, thanks to his heavy exposure to financial stocks like Citigroup and Morgan Stanley (NYSE: MS ) and insurers like Allstate (NYSE: ALL ) and XL Capital (NYSE: XL ) . But his results would have been far worse if he hadn't had some ballast, in the form of stable stalwarts like Pfizer (NYSE: PFE ) and Exxon Mobil (NYSE: XOM ) .
Diversify, diversify, diversify
Diversification is one of David and Tom Gardner's seven core principles at Motley Fool Stock Advisor. The Fool co-founders believe that spreading risk across many investments helps investors keep their cool in down markets, while simultaneously building wealth in the long run.
But proper diversification doesn't consist of merely increasing your total number of stock holdings. After all, stocking up on financials, retailers, and homebuilders wouldn't have served you well in this market -- but adding some exposure to consumer-goods stocks like Procter & Gamble (NYSE: PG ) and utilities like Southern Company (NYSE: SO ) would have shielded you from the worst of the recent market slide. These companies aren't totally immune to a weakening economy, but they are well-positioned defensive plays that have outperformed the market at large this year.
Proper diversification means owning numerous companies across industries, sectors, market capitalizations, risk levels (fast growers versus stable cash generators), and even countries. With diversification, some of your stocks will zig while the others zag -- instead of all dropping at once.
How many stocks should you own? That depends on your level of investing experience and risk tolerance.
Warren Buffett famously invested 40% of his capital in American Express when the company's shares stumbled in the wake of a messy salad-oil scandal. The Oracle of Omaha has also made big bets on companies like GEICO, The Washington Post, and Nike. Clearly, Buffett is quite comfortable running a concentrated portfolio of companies in which he has supreme confidence. But as my Foolish friends Brian Richards and Tim Hanson pointed out, Buffett is a better investor than you.
That's why David and Tom argue that you should own at least a dozen stocks, and -- depending on your investing temperament -- possibly many more. As a general guideline, if any single position is keeping you up at night, you're probably not properly diversified.
If you're looking for some solid stock ideas to build -- or round out -- your well-diversified portfolio, consider taking a 30-day free trial of David and Tom's Stock Advisor service. You'll get detailed write-ups of all the brothers' recommendations, as well as their best bets for new money now. Just click here to get started -- there's no obligation to subscribe.
This article was originally published July 14, 2008. It has been updated.
Rich Greifner owns shares of Freddie Mac and Fannie Mae, but none of the profitable companies mentioned in this article. The Motley Fool owns shares of Pfizer and American Express. Pfizer is a Motley Fool Inside Value and an Income Investor recommendation. Southern Company is an Income Investor pick. American Express is an Inside Value choice. The Fool has a well-capitalized disclosure policy.