Don't Diversify!

By Ryan Delany - Personal Finance & Investing for Military and Marine Corps

"The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile."

--Peter Lynch

Small investors need to exploit their strategic advantages if they are to beat the market. One often overlooked advantage is the option to put all our eggs in a few well chosen baskets.

For the individual investor 5 - 10 stocks is a good number; to own more stocks would require more time and expertise than most laymen have. Each stock investment should be viewed like purchasing a business. This means that you should be well-versed in the industry, familiar with the company and management, and very happy with the income statements and balance sheets. If you examine 20 different companies and only find one that meets your criteria, then only buy one! Don't settle for inferior companies in the name of "diversification."

To be fair, diversification has its benefits--specifically it can spread out your risk. If all of your investments were in tech stocks in the early part of the millennium you would have been in trouble, whereas if only a tenth of your investments had been in tech stocks you would have been better off. My point is not that you shouldn't spread out your risk, but rather that purchasing inferior stocks in different industries could also increase your risk. Spreading out your risk (diversifying, if you will) among several smart investments is a good idea.

Fund managers diversify for a few reasons: one is to spread risk; another is that with their additional resources they can cast a wider net to look for big fish; and finally because they have to spend huge amounts of money. When a manager spots a great stock, he or she can only buy enough of it for a tiny portion of the total fund (that is, without driving up the price). Since funds have so much money to spend, they have to purchase many, many stocks--sometimes hundreds. There are, however, only a finite number of companies to buy, so even with a fund's many resources, the pool of stocks to choose from becomes smaller with each pick. If a manager has to purchase 100 stocks, only 5% of those stocks will be his or her top five picks, while 50% of those will be his or her 50th - 100th pick. I would rather have my money concentrated in my top 5 or 10 picks, then to "diversify" capital among my top 100 picks. Unfortunately for them, fund managers do not have that luxury.

Most people have some level of expertise in one or a few industries. Invest in what you know; never invest in industries that you don't understand for the sake of "diversification." If you know the auto-industry and have worked in it for twenty years, please don't start investing in biotechnology (if you don't understand it) just to "diversify." Pick stocks from industries that you know and understand.

If you find that owning less than a dozen stocks constitutes an unacceptable amount of risk or volatility, then perhaps you should consider choosing more secure stocks. My point is that all of your investments should be intimately familiar to you. Having more than a dozen or so at a time can be too much for the casual investor. Always make your best choices for investing your money, this may mean investing some money in stocks and some money in other vehicles. More is not always better, and a "diversified" stock portfolio does not necessarily mean a safer or smarter one.

Article interests NYSE: NOC, NYSE: LMT, NYSE: RTN, NYSE: GD, NYSE: ATK, NYSE: COL, AMEX: DIA, AMEX: SPY, AMEX: SDS, AMEX: DOG, AMEX: QLD, Nasdaq: QQQQ, NYSE: NYX. Please see our full disclosure at the Wall Street Greek website, and Ryan's disclosure on his bio page.