Besides being geniuses in their respective fields, Warren Buffett, Mark Twain, and Dirty Harry have something in common (and yes, I realize the last one is a fictional character). That is, they can help improve your investment success.
I’ll let them explain…
Diversification is protection against ignorance. It makes very little sense for those who know what they’re doing.
– Warren Buffett
Put all your eggs in one basket — and watch that basket!
– Mark Twain
A man’s got to know his limitations.
When it comes to investing, people have always been told exactly the opposite, usually by index mutual fund providers and others who profit from the advice.
Protect against risk, we’re told, by ensuring your investments are well diversified.
It turns out that just the opposite is true… too much diversification is a bad thing!
Assume you have 100 stocks in equal proportion in your portfolio.
A 100% loss on one of those stocks lowers the overall value of your portfolio only 1%. So you’ve reduced your risk.
However, a 100% rise on one of those stocks raises the total value of the portfolio only 1%. So you’ve also reduced your profits.
What’s the point of doing all the research to select stocks if such dramatic moves have almost no effect?
You’re not investing to avoid loss. You’re investing to make money.
That’s why Mark Twain’s idea is much better: Put all your eggs in one basket — and watch that basket!
Don’t get me wrong here. I’m not saying you should forget about risk. That would be foolish. But you need to break free of the misconception that diversification is the best investment strategy. I can help you do that by debunking two big investments myths: the Efficient Market Hypothesis and the Modern Portfolio Theory.
Let’s start with the former…
The Efficient Market Hypothesis contends that diversification leads to the best returns one can hope for, since there is no chance of beating the markets except through luck. It holds that everything that can be known about a stock is instantly known to everyone and is immediately priced into the stock.
As a result, there’s no way to time the markets or to buy underappreciated securities. Essentially, you can’t beat the market in the short term.
One problem (and there are many) with this theory is that it doesn’t allow for the inefficiencies we see time and again. For example, the bankrupt company Tweeter saw its stock price soar because investors confused its ticker symbol with Twitter’s. That doesn’t seem very efficient to me.
Also, there’s the issue of high frequency trading, where investors use ultra-high-speed computers to get pricing data and place trades milliseconds faster than other market participants. Clearly, all information is NOT available to everyone at the same time.
As for Modern Portfolio Theory, that has problems as well. It stipulates that diversification lowers risk. By holding securities that move independently of each other (non-correlated), investors can generate average returns with below average risk. The idea is that volatility in one security somewhat cancels out the volatility in the other.
So what happens when there’s a major sell off?
As we’ve seen countless times, even though two, or 10, or 500 securities are not correlated, they might still move together. So just when you need diversification to prevent losses, like in a major bear market, the premise doesn’t work because everything goes down together.
I acknowledge that both of these theories — the Efficient Market Hypothesis and Modern Portfolio Theory — have some solid logic, but on the whole, they don’t work for diligent investors. Investors who know what they’re doing and who do the work required of good stock picking are better off leaving these concepts behind.
Fama, the father of the Efficient Market Hypothesis, acknowledges that a simple momentum strategy can turn his theory on its head. In this case, you rank stocks every month based on their last year of returns, and then invest in the strongest ones. The idea is that extreme winners tend to win for a few more months and the losers tend to lose for a few more months.
My point is that security selection can outperform diversification. Buffett built his fortune by focusing on just a few investments at a time. So can you.
And a National Bureau of Economic Research study proves it.
In a paper entitled Portfolio Concentration and the Performance of Individual Investors, Ivkovic, Sialm, and Weisbenner found that investors who held fewer stocks, significantly outperformed those who held more.
However, the authors issued a warning: The correlation between the performance of trades and portfolio concentration does not mean that simply by altering one’s portfolio to hold just a few stocks that performance will improve. Rather, it suggests that some investors with superior stock-picking abilities exploit their skills by concentrating their portfolios in a few stocks.
Ultimately, it all comes down to knowledge and work. The key is finding an approach that makes sense for you, and then doing what’s needed to follow it over time.
Dirty Harry’s right: A man’s got to know his limitations.
|Follow me on Twitter @RJHSDent|
Ahead of the Curve with Adam O’Dell
If you ask many stock-market investors what they know about stock options, you’ll get the same answer …