It's a Good Idea To Diversify in the Stock Market?

It's a Good Idea To Diversify in the Stock Market

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When a beginner starts to invest in the stock market, one of his first desires is to buy more shares. Some Google here, some microsoft there and, as far as possible, a little bit of everything that seems to be at least ok. This is called diversification, or as the popular saying goes, puting your eggs in several baskets.

In this article I will explain why this is a bad idea.

The great Warren Buffett once said: "Diversification is a protection against ignorance, it makes no sense to those who know what to do." Buffett said that because he knows that buying multiple stocks in an attempt to reduce the risks is bad because, while it probably will decrease your risk, your profits will decrease as well, leaving you stuck in the status quo for a long time.

If a company goes bankrupt, you lose money on its stocks and that is horrible. But at the same time, if a company has fantastic profits and become the new darling of the market, your earnings will remain tied to the losses of the company that went bankrupt. Soon, you lose nothing when you could lose, but won't win anything either. Obviously this is an extreme example, but the tendency is that the potential of your investment will be diluted over time.

But if diversifying is bad, then doens't diversifying at all is good? Wrong again.

This is another point that investor just don't seem to get. Having only one stock can be as harmful to you as having 50 shares at the same time. In fact, if the only stock you have gives you problems, as your money is all there, your losses could be fatal, and your savings? Will be gone, forever. It is extremely dangerous to invest in a single stock, the upside potential is enormous but the potential loss is total.

The solution to these problems is very simple, stay in the middle. Do not own too many shares nor too little. Remember what Buffett said, only diversify if you have no idea how to invest in the stock market. If you do not want to study and therefore don't want to take the stock market seriously in order to enrich one day, diversification will protect you from your ignorance. You might not get rich, but at least you will be safe. Poor until the day that you die, but safe.

On the other hand, if you want to invest rationally, avoid having many different stock. Select some (about 20) and then compare them with each other and just keep the stocks of companies with better fundamentals and greater growth potential for the future. In the end, you'll likely end up with 6 high quality stocks, one of each different sector. That way you will not be investing too much or too little but just enough.

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