Webconsuls Blog

Wednesday, January 7, 2009

To Diversify or Not To Diversfy

One school of thought is that investors should be well diversified. If one investment goes down, then another may go up and things balance out. One tenet of those that preach diversification is that no one can predict movements in individual stocks or sectors, so diversify and reduce your risk. Those that preach diversification also generally think that the at any one time the market is right and future changes are unpredictable. Another concept, which may be a little tough to grasp, is that throughout history a "valuation" of the world has gone up, except perhaps for the Middle Ages. With technological advances one expects the world to get more valuable.

However most who have made great fortunes did little diversification. Suppose Bill Gates had said to himself, when his Microsoft stock was first worth $100,000 had probably represented a large portion o f his net worth, "Gee its crazy to have so much of my net worth in one company, I should sell 99% of it and put the rest in a mutual fund." And did that repeatedly. You do not read about investors who made fortunes by diversifying, but rather because they made it "oil" or "real estate" or Microsoft. Even Warren Buffet keeps his holdings rather small.

Investors who do not diversify think that they with their brains and hard work can outperform the market over time. They think that the best you can hope for when you diversify well is to get "average" returns and so if they are smarter than average and work harder than average then they should exceed those returns.

The safety aspect of diversification can not be denied. We rarely read about those that had all of net worth in Enron and saw it vanish, or Lehman Brothers etc. Unfortunately there are people who were in that boat.

Diversification has a cost. You either need to pay someone to diversify for you, ie a mutual fund, or you need to pay the transaction costs of buying multiple assets. It took $100 to buy our Fortune Magazine group of 10 stocks but only $30 to buy 3 mutual funds. If you only had $100 then the commissions would have precluded buying the Fortune Magazine group. If you had $100,000 then the commissions would have been a much lower percentage of your assets.

If you think you are really good, then research the 10 companies on the Fortune list, pick 1 or 2, and see how you do against the portfolios.

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