D-D-Diversification Junior

[Justo]

   I had a little argument the other day with someone about diversification. Well not so much an argument but more of a debate. Now, I understand diversification and the reasons for why it is used, but I don’t think people realize that there are also some pitfalls that come with it. But let’s look at the positives first.

Positives:
1.   Safety – diversification “should” provide safety in that by being diversified there is greater probability that one’s portfolio will fail. I completely agree with this, however it must be clear on what being diversified means. It does not mean owning a bunch of different stocks that are all in the same industry. It means you need to own a mining industry stock, a tech stock, a clothing store stock etc. That is true diversification. Owning a large number of stocks in the same industry is not being diversified. FURTHERMORE, one should also have some bonds in their portfolio, for an extra level of safety and to be truly diversified.
2.   Picking Winners – By owning more stocks you greatly increase your chances of picking the winners (whether you know what you’re doing or not doesn’t really matter). By picking the winners there is a greater chance that your portfolio will increase in value, and that these winners will offset any losers that are in the portfolio.

Negatives:
1.   Reduced Gains – for the enterprising investor who has a strong understanding of business and stocks should diversify less so as to increase the gains that are returned to him. By being diversified not only do you pick winners you also pick stocks that may not perform as well as others. This will actually decrease the amount that could have been owed to you as stocks that perform poorly will dilute the success of stocks that show a greater performance.
2.   More Time and Effort – By not being diversified you must be willing to put in the time and effort into researching stocks. If you are not going to do this and are just going to pick stocks by guessing or basing valuations of companies by the price of their stock, then you definitely need to diversify. However, if you’re doing your homework, you can diversify much less.

NOTE: Not diversifying does not mean that the level of risk increases.  It simply means that you must put more time and effort into the stocks you choose.

Personally I am against diversification. It dilutes the gains that I could have made, and there are too many people out there who simply throw the word “diversification” around to convince their customers that their investments are safe. I believe that there are too many Investment Advisors out there today don’t really know what they are doing, so they tell people “Pick X, Y, Z, P, and Q because I don’t really know what I’m doing. So if X and Y go down P and Q should go up, and vice versa. Oh and Z is there in case all the other ones fail.” If I wanted to gamble I would go to a casino.

If we also look at some of the richest people in the world (Warren Buffet, Bill Gates etc.) we see that their holdings are not diversified. The majority of the stock that they own is in their respective companies. That is a large reason to why they are wealthy.

In sum, diversification can provide a larger degree of safety, but one should still learn everything about the stocks that they are investing in before they give the go-ahead. It should be used only if you are not an enterprising investor and do not have the time or effort to put into your portfolio. However, if you want to be wealthy, I advise against diversification. You’re definitely going to have to do your homework though.

Thanks for reading! I’m still searching for another good stock to write about, so stay tuned for that!

Oh and feel free to follow me on twitter!  Just search for Justin Gruenthaler! I promise that I’m not one of those spamers lol.

[DCA]

Then there is the little sister of diversification.  Rebalancing:  the act of selling some of your winners to buy more of your losers.

I think diversification and re-balancing are systems used by stock brokers to generate commissions.

D

[garilou]

Justo,
Your reflections about diversification are very interesting.
In general, I really appreciate your posts.

Why don't you tell us a little bit more about you?
(I am not a big twitter)
How long you have been in the stock markets, what brought you to this interest, what type of "investor" you are.

Why did you add "Junior" to your subject? ( I love the D-D-Diversification)

Diversification is an important questions that is often replied with "clichés".
You summarized the question in a very interesting and intelligent manner. This does not mean that I totally agree, but it makes an interesting and refreshing reading.

I would just comment this affirmation: (in your positive section)
"By picking the winners there is a greater chance that your portfolio will increase in value, and that these winners will offset any losers that are in the portfolio."
The reverse can be true too! The upward moves can me very impressive for a day or 2, the downward move can be terrible, last very long (look at Ford), and offset your wins.

You often read these times: "It's not a stock market, it's a market of stocks". This seems so true!
On huge days down (or up) like we have seen in the past years  (and recent days), most stocks move in the same directions.
When metals go down, banks go down, because banks are not what they used to be.
When gold goes up, this does not mean that you gold miner will up either.

During the first part of the crisis, there were defensive stocks: pharmaceuticals, potash and agro stock, it can be a big mistake to think that they still are defensive stocks: they have been over bought, and they also suffer form the crisis.
Look at Cott: this was a defensive stock, but then speculators had the prices of the agricultural commodities go so high, that Cott saw it's margin decrease dramatically.

I remember when it was thought that a good portfolio must include some gold, banks, utilities, blue chip techs, consumer staples, bonds or equivalents, a reasonable part of riskier stocks like bio techs, start-ups.

I tend to agree with you that diversification can bring to an almost zero sum at the end of the day.
The example of your financial adviser:
"So if X and Y go down P and Q should go up, and vice versa. Oh and Z is there in case all the other ones fail.” 
is exactly what keeps me away from financial advisers.
But more: the financial advisers usually (openly or not) work for a firm where they are pressured to push this or that stock.

And you must have heard the buy argument: "Buy this one, it is sooo  cheap at $20. It used to be a 40$ stock!"
Or this stock is "poised to explode" with a forward P/E of 10!
 

Unlike the general accepted rule that says a portfolio should be at least 90% invested, I am rarely invested that much (but as I said somewhere else, I turned to be more of a trader then an investor).

I do have a very diversified "watch" portfolio, with stocks in all different sectors, all ranges of prices, and about half/half Canadian and American, and some Chinese stocks, and I always trade those stocks.

(And I am always ready to buy some reverse ETFs.)
Every 2 or 3 months, I eliminate a few where I see no interest, and replace them by others (which gives me time to do my "homework")
I watch each of them daily. My huge Excel sheet gives me signals, because it would be hard to check all 40 every night).

But I rarely own more then 5, maximum 6 stocks at the same time (distributed between 4 portfolios, one or the other - except my RRSP -being sometime completely at cash), often less.

Cash allows quick "in and out" on a stock that you've never heard of, that can pay up to 15 to 20% in 2 days, without having to think of "rebalancing".
But I do this very rarely.

And I am never at cash because the market is crashing: there are always good opportunities in a crashing market.
I'll stay at cash if I don't see any clear opportunity.

But those on which I have open positions I watch extremely closely.

Am I diversified? Yes but horizontally... I mean diversified on a timeline, but seldom at the same time.

I do rebalance  sometimes, not often and not as DCA said:
I might buy more of my winners... and just sell my losers: with $7.00 fees, there is no reason to risk increasing a loss: a looser can stay a looser for very long.

In  my case,  most of the time the size of my position is OK, as dictated by my system but sometimes it says: "sell some", or "add some."

This does not mean that my "system" decide for me: some fanatics of the TA think that the news are already priced in, the same with the results or the guidance. This is not true.

The "sell some"  or "buy more" signal do not depend on the price, or the size of my gain, (the market really does not care if the stock is a big or small gain for me, but on 3 factors:
1. the present risk evaluation (the higher or lower volatility),
2. the risk that I have accepted before I bought, and
3. the available cash in the account.

But if the stock was a huge gain for everyone, (like I had last week with AAA and CDV, then I sell, even if know 100% that I'll soon be back on both).

But today's looser might become a winner some other time, so even if sold, it does not necessarily go off my radar: it might be a sweet short candidate.

I was one of the first to short RIM systematically, a few years ago, when there were no iPhone yet, when everyone told me I was crazy. But it never went off my radar, and I bought it twice in the past 4 months.
Same with SXC that I bought and shorted so many times.

It took me time to overcome some fears: a stock that you do not own cannot hurt you (it can hurt your pride). But I was long afraid to buy a stock that either had hurt me, or had been a winning short.
(Agrium would be a good example: I started watching it as as potential buy when I realized that it was (at that time) a perfect short candidate.)

As a result: when I closed my short, I missed a fantastic rally (totally unjustified, but the markets are not logic).
And now, all what is left is a probable good short once again.

There a stocks that you kind of get to know (like SXC where my trades are most of the time winners), and others that I do not understand at all (like Telus, where I lost much more often then won).

I felt reassured when I heard an interview with one of the very know billionaires ( I can't remember which one it was) who said : "When asked how I became billionaire, I reply: by taking my profits too early").
This made me feel good, because I often do take my profits too early.
I prefer to set a target then a stop loss 
But I always felt stupid because I kept reading: cut your losses and let your profits run.
This used to be true, since a few years, much less so.

I can't wait till you tell us your next good stock is, and mostly to see how you determine that it is a good stock 

Then I might tell you about my preferred ones.

Till next

Louise

PS Gees this thing is almost as addictive as cigarettes and horses...
PS 2: I am writing this around 4:00 AM 6 to 7th of May: the world seem terrified by the elections in France and Greece.
It will be interpreted as so anyway, but the down trend was there since a few weeks already.