The Need for Diversification in The Stock Market

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Diversify or Die. Diversification among many individual stocks and various stock groups is necessary for any successful investment plan.

Why is it that some people only buy one or two stocks? Others may have 15 stocks but have 50 percent of their investment assets in just one of those 15 stocks. In Wall Street we refer to this type of behavior as concentration. Some firms call it over-concentration. When this happens in a brokerage firm it is always considered dangerous. It is so dangerous, in fact, that if the brokerage firm is using a concentrated stock position as capital, then the market value of the security in question is given a haircut. This means that the full market value of the security is chopped by some fixed percentage in any capital computation. In other words, if you are over-concentrated, you don't get full value.

Some of you may have margin accounts. As you know, StocksAtBottom.com advocates cash ownership of stocks. If you own stocks on margin, it is our opinion that you will get sold out on margin. Normally in a margin account you put up 50 percent of the value of the stock you acquire in cash. If equity falls below 35 percent, you get a margin call. Now, brokerage firms love it when clients have 15 or 20 different stocks in a margin account. If there are some bonds in that account, guess what, they love it even more. Why? Because brokerage firms know that stocks represent risky investments.

Something can always go wrong in any one situation. Maybe something can go wrong in any two situations. It's tough to see something go wrong in 15 situations. That is the essence of diversification. SPREAD THE RISK AROUND. It makes a lot of sense. Some investors own 50 to 100 stocks. This is because they think they need that many to achieve the investment goals that they set out for themselves.

In business school at a master's degree level they teach you that to achieve true diversification you need to own something approaching 14 equity positions. It has been the experience of StocksAtBottom.com that 6 to 10 different equity positions is sufficient to achieve diversification. The one thing we know for sure is that it's not one stock or two stocks. Own one or two and you get killed.

Putting all your eggs in one basket

We advise all investors to own several stocks and to own more than one sector. Own more than one type of investment (that means equities, bonds, real estate, cash, you get the picture) or you will have problems. Sectors refer to stocks with broad themes. Examples are:

  • Energy
  • Semi-conductors
  • Housing
  • Auto
  • Consumer
  • Airlines
  • Personal Computers
  • Technology in general

If you own 10 stocks, but they fall into only 2 sectors then you really have not achieved diversity in your portfolio. You see, when they come to get Ford Motor, usually General Motors is not that far behind. By the way, it's great on the upside to own everything in one sector when that sector is going your way. There's probably not a greater high in the world than when everything you own is going up. On the flip side, when you are overly concentrated in a sector that's heading down, lower and lower every day, there is no worse emotional low. The depression can be almost unbelievable.

There's also the issue of owning more than one type of investment. There are equity investments, which are stocks. There are real estate investments, and bond investments. There are also venture capital investments, precious metals, and others such as oil and gas. To a large extent, you achieve diversity in your investment strategies by owning different types of investments, as well as investing in different sectors.

Let's go into a few real life examples. We at StocksAtBottom.com believe we have already made the equivalent of a lifetime of investing mistakes, so learn from a few of ours.

Arrow Electronics

It was Christmas week in the early 1980's. One of us was sitting at Bear Stearns as a limited partner at the time. We were doing very well as stockbrokers. It was the period of full commissions (no discounting), and clients were doing 10,000 share trades in $50 dollar stocks. Taking home an income of $500,000 to $1,000,000 in a year was no big deal at the time.

We were loaded up on Arrow Electronics, a NYSE company in the semi-conductor sector. Business was fantastic, the future was bright, and things could not have been better. Since we were involved on the banking side as well, we had an open line of communication to the company. We knew we had a good thing going.

The telephone rang on one of those beautiful days prior to Christmas when New York City is the place to be, Rockefeller Center all lit up with a 50 foot Christmas tree and all. "Hello." A harried response, "There's been a fire at the Tarrytown Hilton Executive Center, a lot of people are dead." "Okay, that's terrible, how does it affect me and by the way, what's for lunch today?" "Buddy, you don't understand," the dead pan voice says. "What don't I understand?" "The entire executive leadership of Arrow Electronics was in that fire." All of them, every one of them had been killed by this monstrous tragedy.

It was the worst Christmas imaginable for the wonderful families of this dedicated group of execs. The families never recovered, the company never recovered in terms of the people that were left, and the stock took years to recover. It plummeted from $32 per share to $4 per share in a matter of days. The recovery was slow and hard, it was agony all the way back on this particular stock.

Arrow Electronics is an example of putting all your eggs in one basket. It is an example of owning just one stock. SAB does not care how much you know about a company, things can go wrong and do go wrong. You simply cannot own just one company because the risk on the downside is too great. YOU MUST DIVERSIFY IN ORDER TO SPREAD THE RISK.

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Richard Stoyeck
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