Diversification
The only way to
invest |
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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.
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? |
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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.
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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% |
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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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