The first thing every investor learns is not to put all his eggs in one basket, which means diversify your portfolio with a blend of securities or, in the case of a stock portfolio, a larger number of stocks. Diversification makes sense as long as you understand that over-diversification is as bad as under-diversification.



The main purpose of diversification is to protect you from losing money due to the risk involved in the stock market. This stock market risk is composed of two kinds of risks: the overall market risk and the individual business risk (let's ignore inflation and currency risks in this post for simplicity). The market risk is the risk caused by the fluctuations in stock prices. Many factors can cause these fluctuations, starting from changes in individual companies, to revisions in sectors and changes in the overall economy. The fact that there is no definitive way to predict the direction of these fluctuations in advance, combined with market globalization, makes it almost impossible to reduce the market risk. In other words, unless you have a fortune teller's skills, no matter which or how many stocks you hold, your portfolio will fluctuate in a manner similar to the market (on average). As a result, in a bearish (declining) market such as the market we are currently in, your picks will probably go down (again, on average),and vice versa - if the market trend is up, your portfolio will benefit from it.

Observe the portfolios of great market gurus; almost all their portfolios lost value due to the market drop in the past year. For example, Bill Miller and his Legg Mason Value Trust beat the S&P 500 from 1990 to 2005, but he's down 30% a year to date. Investment expert Marty Whitman's Third Avenue Value Fund, which returned more than 14% a year since 1990, is down about 17% so far this year. Even the all-time greatest value investor Warren Buffet's company recently suffered major losses.

However, a wise diversification can definitely decrease the individual company risk while not reducing your chances to beat the market. Obviously, holding only a few stocks in your portfolio is much riskier than holding 500 stocks. However, the additional risk rapidly decreases as the number of stocks increases; the market statistics show that if you hold 15-20 stocks in your portfolio, even if they are randomly chosen, the risk will be only slightly higher than the market risk.

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 needed to. Different numbers work for different people; it all depends on the level of confidence you have in the companies you chose. The level of confidence in your investing strategy can be dramatically improved simply by practicing your skills on virtual stock trading services such as Yalicoo. By using these services you'll experience real time occurrences thus learning to adapt your strategy to the real market behavior.

As a rule of thumb, it is usually wise for novice investors to hold around two dozen stocks in their portfolio (but not more than that). As your level of research and margin of safety on each company rises, experienced investors can safely concentrate their portfolio on much fewer ideas, setting it to grow more quickly. In any case, remember that diversification by itself is not a magic word; it won't do you any good if you don't know what you're doing. Therefore, do your homework and practice virtual stock market investing before putting your real money in the market.