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Diversification vs. Concentration

You've probably heard the saying, "don't put all of your eggs in one basket."  Whoever came up with that was probably someone with a diversified investment portfolio because it's a very pertinent topic in personal finance.

Diversification is the strategy of spreading your money out among a number of investments.  The thought is that if you own many stocks and one does poorly, your portfolio won't be affected as much.  But also, if one stock does very well, your portfolio won't reap all of the benefits.  So you are supported by all of your stocks, rather than depending on just one or two.Concentration is the exact opposite strategy.  Someone who has a concentrated portfolio may own just a couple stocks.  If those stocks do really well, his portfolio will do really well too.  But if they do poorly, he can end up losing a lot more money than planned.  By having a concentrated portfolio, an investor is exposed to more risk but can earn higher returns.

It's highly unlikely that a new investor will be able to achieve diversification on their own.  Going out and buying 50-100 stocks is pretty difficult to do.  If you invested $1,000 in each of them, you'd need $50,000-100,000.  Not to mention that commissions will cost you a fortune.  So your best way to do this is to invest in a mutual fund or exchange-traded fund (ETF) that will buy many stocks for you.So which one is better?  Well, it's pretty hard to say.  Most investment advisors will tell people to own many stocks because putting all of your money in one or two stocks is too risky.  However, some investment professionals will argue that concentrated portfolios are better because it's easier to keep up-to-date and follow your companies when there are just a few of them.  They feel that people with diversified portfolios are clueless about the latest happenings with most of their stocks.  So, again, which one is better?  Here at TeenAnalyst, we generally recommend a combination of diversification and concentration.  We recommend you put at least half of your money into a diversified mutual fund.  You can then open another account where you own just a few stocks and follow them closely.  But the general rule of thumb is that it's better to be more diversified than concentrated.  However, that's entirely up to you.

 

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