Part I: Avoid Diworsification
Part II:………….
In a March 26 article, the Wall Street Journal made reference to the past ten years as being the “lost decade”. This could not have been more true when you look at the S&P 500 Index. Investors who utilized passive index funds over that time frame have averaged 2.88% per year for the 10 years ended 06/30/08. This paltry pittance of a return didn’t even beat inflation.
Yet, we know that the past 10 years have not been a disaster for most of us who use an active approach to managing investments. Those who were looking to diversify away risk by owning an index fund have gotten slapped silly like Larry in a Three Stooges movie. Indexing does not work.
Instead of buy low, sell high, indexing guarantees that you will buy high and higher because the better companies and sectors perform, the greater the weighting in the index. As they peak in value, more money that goes into index funds goes into those stocks that are becoming overvalued. We saw this with financial stocks. Now, we have been seeing this happening with energy stocks. Index investing is counterproductive.
So, how many stocks do I need to have adequate diversification? Fifty? One hundred? Five hundred?
To me, the number seems to be between 20 to 25, assuming you have representation from more than just one industry sector. More than 20 or 25 stocks, doesn’t help you achieve much more of a benefit of diversifying. One can reduce risk through diversification, but only so far.
Warren Buffet, rather than spread risk over a large number of stocks, prefers to concentrate on a limited number of companies. In his words, “a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort level he must feel with its economic characteristics before buying into it.”
I prefer this “rifle” approach to investing, rather than a “shotgun” approach of buying 100 – 200 stocks, or 20 different mutual funds.
What we’re talking about with diversification is really “risk management”. How do you defend against a market downturn? Well, using an index approach, which focuses on the conventional modern portfolio concept of diversification, is limited at best, and really inadequate when you think about it. With index investing, investors must be willing to accept what the market gives them. Average returns. Hey, that’s what we’ve always aspired in life to be: average. Yeah, right.
To me, a better way to play defense is to recognize market excesses that are created, and simply avoid them. A sector rotation strategy, if you will. Excesses have been easy to identify in the past 10 years: tech, real estate, financials. Perhaps now, even energy and basic materials. Recognizing those excesses, extremes or “overbought” situations in the market, and staying away from them, is the other side of the investment performance coin.
You don’t need to own 100 stocks, or worse yet, 20 different mutual funds. Just focus on 20 – 25 names in the “right” sectors, and watch them closely. When the time comes when everybody is in love with those stocks, start to look for other areas to take positions in.
Currently, I continue to screen for stocks in the following sectors: tech, financials, biotech, drugs, forest products, business products/services, environmental services, banks, REITs and retail. Money has been rotating to these areas, out of energy, materials and industrials. Should the dollar show further signs of strength, I would expect this trend to continue.
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