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How to Think About Diversification

When learning about investing, you'll often read about the importance of diversification. Well, true, it's important. But it's almost as bad to be overdiversified as underdiversified.

Let's look at some examples to see how this works. Imagine that your portfolio consists of just two stocks, A and B. You have $5,000 tied up in each, for a total of $10,000. If A's stock price suddenly drops to half what you paid, your portfolio's value sinks to $7,500. It falls by 25%, just because of one stock's move. That's exposing yourself to quite a bit of risk.

At the other extreme, let's say that you hold 25 stocks, with about $2,000 in each, for a portfolio total of $50,000. Each stock represents 4% of the portfolio's value. Imagine that one of your holdings doubles! It's now worth $4,000. But, since it was such a small part of your total portfolio, its amazing 100% surge will boost your portfolio by only 4%. If you hold only 10 stocks (in equal measure) and one of them doubles in value, your portfolio will gain 10%. See the difference?

There's no absolute best number of stocks to own. Too few and you've taken on too much risk. Too many and you've diluted the power of your holdings more than you had to. Different numbers work for different people. If you have 20 stocks, and you're confident that they're all strong performers, you could do well. But if you think that only 15 are truly outstanding companies with great growth potential, you should consider trimming your holdings to just those 15. The idea is to invest your money in your best ideas. By concentrating your portfolio this way, you set it up to grow more quickly.

A final consideration is that, to be a responsible investor, you'll need to follow your companies' progress at least once a quarter, reading news reports, financial statements, and annual reports. If you own stock in 30 companies, this can be very hard or even impossible to do. Most people find that between eight and 15 companies is a manageable number. (Make sure they're companies that actually interest you so that you can stay awake when reading up on them.)

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