There's a simple investing reality: The more you concentrate your portfolio in a single stock, the greater the effect on your net worth when the stock moves. Looking at the big movers from this past week, if you had a one-stock portfolio containing only Level 3 Communications (NASDAQ:LVLT), which has risen 26%, then your portfolio gain would be (drumroll, please) 26%.
Sounds pretty good, right? Pick one stock, and it takes off. The flip side, of course, comes from Sea Containers (NYSE:SCRa), which dropped 40% this past week.
Charlie's chutzpah
Could you stand having 40% 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 twice as much pain from a loss as they do joy from an equal-sized gain. 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 does.
Holding shares in one company, or a few companies, would be spectacular if those companies were long-term sizzlers like Caterpillar (NYSE:CAT), Student LoanCorporation (NYSE:STU), and Yahoo! (NASDAQ:YHOO). But it would be disastrous if you were heavily levered toward Lucent (NYSE:LU), 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. 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 creating 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 can help you ensure that being wrong about any one stock isn't fatal to your financial future. If you hold 20 stocks and one collapses, it's a much smaller hit to your portfolio.
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This article originally ran on March 1, 2006. It has been updated.
Bill Mann doesn't understand why ice cream isn't considered a vegetable. He holds no companies mentioned in this article. Bill invites you to take a guest pass to see what Hidden Gems is all about. A 30-day pass is free!
