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Diversification

The only way to invest

Each year millions of investors lose money in what they perceived to be good and logical investments. In the end, it's not logic or research that causes failure. It's playing against the odds.   If you are not consistently beating the market year after year, then I assure you the problem is with your Initial Position Size.  The most important aspect to your investing is money management. Money management is that portion of your investing system that tells you how many units (position size) of your investment you should put in a given investment. It represents how much risk you should be willing to take or how diversified you should be.

Using the GetFolio.com Strategy, I have been experimenting with position sizing using real money since 1990. Initially, it was hard for me to accept the idea of investing small amounts per trade. But at the same time, I knew for sure that I was subjecting myself to a lot of stress by investing heavily in individual positions. Famous investment gurus such as O'Neill or Lynch -- as well as many others -- tell you to research thoroughly and invest in the 10 best companies. I say that's all fine and dandy in theory, but in reality, your personally chosen best companies will often turn into mediocre performers. You can blame the failure on poor research, but the simple fact is that billions of professional dollars are regularly invested based on great research, and despite all this, many professionals still fail.

Proper Diversification:
Today, through the use of my Position Manager, I simulate a mutual fund in my own personal portfolio. I don't look to make a fortune on any one stock, but I never lose big either; it's my overall portfolio's growth and personal peace of mind that I am after. The reality of investing, is that your ROI is simply dictated by the number of stocks in your portfolio and its cumulative volatility. Managing fewer stocks severely handicaps your success. Can you make money with less diversity? Not consistently. The reason is quite simple and mathematically irrefutable: the fewer stocks in your portfolio, the larger your position sizes inevitably will be and consequently, the larger your margin of error.

Today's Comic

Volatility Swings
Suppose a crystal ball showed you 20 wonderful stocks that would appreciate by 25% in a year. Would your portfolio be up 25% in one year?
Surprisingly enough, not only will your portfolio not be up 25%, but in all likelihood it would probably be down. You see, while your entire focus was on the fact that these 20 recommended stocks were going to appreciate by 25%, you failed to realize that volatility would have a greater impact on your ROI. Each stock that you expected would make a 25% return did in fact do so, but before it did, each stock fell drastically due to negative market sentiments. In all likelihood, panic would have set in and your stop loss orders would be filled. Subsequently, you likely would end up with a drawdown for the year.

If you think the above is an unlikely scenario, consider this: with the market as volatile as it is, the average stock regularly swings 50% in either direction. With these kinds of volatility swings, you would suffer a substantial drawdown and a major cash crunch on any market sell off. In fact, the odds of you beating the market consistently is directly related to your ability to control the volatility in your portfolio.

One could easily argue that the 20 stocks listed below represented an excellent buying opportunity in 2000. I, on the other hand, will argue that the fact that these stocks represent great value should be secondary to the risk of 68.8% volatility swing. Had you bought these 20 stocks in the year 2000, your portfolio would have suffered a substantial drawdown, and I doubt you would have survived it.
 
# Stock Volatility
1 IBM 72%
2 JCP 63%
3 AMGN 77%
4 IP 37%
5 INTC 90%
6 C 72%
7 MSFT 52%
8 KO 29%
9 AMAT 90%
10 AOL 127%
11 CAT 49%
12 F 73%
13 G 31%
14 GE 58%
15 GM 59%
16 HON 94%
17 SUNW 138%
18 MO 36%
19 NKE 46%
20 ORCL 83%
  Average 68.8%
How much should you diversify?
I have a question regarding the stated results of highly diversified investment newsletters. Are these newsletters really practical for the average investor? I mean, many of these newsletters recommend a large number of stocks in order to match those results. "I would need to spend a large part of my day monitoring such a portfolio!" Hard-core investment letter types pooh-pooh this. With modern software, they say, you can review 30 stocks or more in just a few minutes. And there's a strong argument that you should do this.

Years ago, the conventional wisdom among finance academics was that you could fully diversify against stock market risk with a portfolio of only 15 to 20 stocks. As in so many other ways, the conventional wisdom has been revised -- basically because individual stocks have systematically become more volatile. Now, research suggests the diversified portfolio requires at least twice as many stocks.

Mark Hulbert's at the Hulbert Financial Digest seems to indicate that larger portfolios achieve systematically higher returns than portfolios with 10 to 20 stocks. Of course, not diversifying can result in spectacular success. The top-performing letter of 2004, according to performance data compiled by the Hulbert Financial Digest, was Fredhager.com, up 150.3 percent. But Hager achieved its success in large measure with one stock: Rambus (RMBS) , a designer and licenser of intellectual property related to memory chips.  Yesterday, Rambus hit an air pocket (not for the first time) when its fourth-quarter showed unexpected declines because of the cost of the litigation which is possibly its main claim to value. The stock fell more than 16 percent Wednesday, closing at $17.85. More about Fred.

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