Diversification- A Reason Against

 

Warning do not attempt this without knowing and understanding that this could be a zero sum game.

Almost everyone I know wants to get filthy stinking rich. They would do just about anything to get there except risk any of their money.

When it comes to getting rich the average investor sneaks up on it in the same way as they buy a lottery ticket. ‘Here’s a dollar, make me rich.’

In order to get rich in the stock market investors have to do the very opposite of what they have been taught to do. The single most important rule to ignore is using diversification as a method of money management.

Diversification, the cornerstone of investment planning, reduces risk and, most importantly, return. Yes, dear reader, diversification, the fundamental that every financial talking head tells people to do reduces return on investment. No one will ever make a bundle by diversifying.

Aggressive investors are better off to ignore diversified investment portfolios such as mutual funds and ETFs and concentrate on buying a handful or maybe just one or two stocks. Now before you light torches and march up my driveway for being a financial heretic allow me to explain.

Jack Bogle of Vanguard fame believes in diversification – sort of. He thinks you should own an equity fund for growth and a bond fund for age protection when markets go poof. You’ll never make a lot of money following Bogle but you won’t lose any sleep worrying about your investments either.

Warren Buffett who manages the huge Berkshire Hathaway with approximately $47 billion in assets has only 37 positions as of June, 2010. To put this in perspective the Fidelity Contra fund has over $55 billion dollars of investor money but it is spread over 482 issues. Obviously Warren Buffett doesn’t believe in diversification. Warren is all about maximizing return on his investor’s money. If a company stock is really compelling Warren will just buy the entire company. About 25% of Berkshire Hathaway money is invested in Coca Cola. Not a one of my clients has 25% of their money in one asset unless you count their homes.  (No, I am not telling you to buy Coke! But, you see my point about buying a company with a great franchise, a wide moat and owning it for a very long time.) It is also easier to monitor a few holdings versus a portfolio that resembles a weekend ‘honey-do’ list.

Jack Bogle does not manage investments, nor did he ever. Everything Jack tells us has a bias because of his role at Vanguard creating low cost index funds and the fact he is an investor just like you and me. Jack’s equity philosophy is to match index returns not to exceed them. Warren Buffett, on the other hand, is both an investor (he eats his own cooking) and portfolio manager. Over the years he has made his investors, and himself, a lot of money.

Warren is all about making as much money as possible while Jack is about preserving what you own. Warren is not a trader. Once he owns a stock he generally keeps it forever. He also does not buy anything he doesn’t understand. (Yes, he does sell what falls out of favor or reduces his holdings.)

Common sense tells us that if you are an active investor there can be only one investment that is the best performer for the moment. Every additional investment  decreases your total return.  The more you own the less your total return.

The average investor diversifies and allocates their portfolio into producing mediocre returns.

The truth is most of us are uncomfortable owning only one or two investments. The majority of investors are not trying to hit home runs but returns that are slightly better than inflation and taxes combined.  But for the ultra-few who are looking to hit four or five baggers owning one or a handful of stocks is just the ticket to either riches or the poor house.

One place for the uber-aggressive investor to start is the company 401k. In the past advisors cautioned against owning too much company stock because of the weakening economy and the rich valuations. Now with the economy getting traction and many stocks below their all time highs investors just may find rewards right where they work.

If you’re inclined here’s a few more ideas to get you started:

• Make sure you have enough years left to overcome any mistakes you make now.  Trust me – you will.
• Define who you are: Aggressive-Trader or Aggressive-long-term investor.
• Because you’re trying to get rich it’s okay to invest all your money into one stock. Remember: Buying more than one reduces your return .
• Cut losses quickly. Make a promise and keep it.
• Know when to sell and book your profit. If you’re trading pick a target number and stick to it.
• Don’t chase a hot stock.
• Don’t be afraid to lose money.
• Learn all you can about the what you want to buy, the overall market, technical side of investing, options and leverage.
• Study your stocks before you buy.
• Don’t buy on tips, because you have a gut feeling or you like the stock for some unexplainable reason. (It’s like betting on a horse because of the length of its tail.)
• If you buy and sell in your retirement account you lose valuable tax benefits.
• Buy what you know and only after doing your homework.
• Don’t try aggressive investing as a part-time hobby. Markets move quick and you have to be there to make decisions.
• Finally, if it seems like work then quit and buy some funds, kick back and let someone else manage your money.

Questions call Paul @ 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.