When to Concentrate

This comes from the files of "Do not as I do."

There's a simple investing reality that says that the higher the percentage of your portfolio that's concentrated into a single stock, the greater the effect on your net worth as the stock moves. Looking at the big movers from this past week, if you had a one-stock portfolio containing only Motley FoolHidden Gems Watch List company eFunds (NYSE: EFD  ) , which rose 19% last week, your portfolio would have risen (drum roll) 19%.

Sounds pretty good, right? Pick one stock, and it takes off. The flip side, of course, comes in the form of LCA-Vision (Nasdaq: LCAV  ) , which dropped 17% this past week.

Charlie's chutzpah
Could you stand having nearly a fifth of your portfolio evaporate in a single week? Most people, when they look deep inside themselves, cannot. Financial behaviorists have found that the vast majority of people feel double the pain of a loss as they do joy from a gain of equal size. But if you hold one stock and it goes up substantially, you're going to become quite wealthy. What's not to like about that? It's less work following a single company than a bunch of them, right?

Charlie Munger has famously savaged diversification as the refuge of the know-nothing. The logic here is simple: Great ideas come by only once in a while, and when you get them, you pounce with as much money as you can muster. And he's absolutely right -- for Charlie Munger, wide diversification would be a ridiculous notion. There aren't 50 people in the world who have more investing knowledge and business acumen than Munger.

Holding shares in one company, or a few companies, would be spectacular, if those companies were long-term sizzlers like Valero (NYSE: VLO  ) , Toll Brothers (NYSE: TOL  ) , and Capital One Financial (NYSE: COF  ) . It would be disastrous if you were heavily levered toward Nortel (NYSE: NT  ) , which has sunk over the past five years. The question is: Would you want to tempt disaster in order to potentially reap riches?

The problem
Most people, when they really look deep down inside themselves, would not. And more importantly, most people should not. The only reason that you should consider really concentrating your portfolio (and here I mean fewer than eight selections) is if you commit to knowing a ton about these businesses and have the utmost confidence in the earnings estimates you build for them. Oh, and by the way -- being confident might not be enough. You also have to be rational in that confidence. After all, drunks messing with firearms might be pretty danged confident, too. That doesn't mean they aren't causing an awfully dangerous situation.

The solution
Because most people don't have time to go so deep in researching individual stocks, it makes much more sense to be diversified. Broad diversification is a method to ensure one result: that being wrong about any one stock isn't fatal to your financial future. If you hold 20 stocks and one collapses, that's a much smaller hit to your portfolio.

At present in our Hidden Gems newsletter, we have 39 current stock recommendations, all small caps, all companies that we believe will be market beaters. Our extreme discipline in focusing on companies that have superior economics, top-flight management teams, and underappreciated competitive positions have helped us deliver excellent returns to our subscribers. Of course, we won't be right about all of them, and some have disappointed in the past, such as TransActTechnologies (Nasdaq: TACT  ) . But the combination of discipline and diversification has paid off extremely well, and we believe it will continue to do so over the next decade.

Bill Mann thinks curling would be even more fun to watch if the stones exploded upon contact. He holds no companies mentioned in this article. eFunds is a Hidden Gems watch list company. Bill invites you to take a guest pass to see what Hidden Gems is all about. A 30-day pass is free!