Diversification Basics

               I have heard many different opinions on what constitutes proper diversification.  First, we can ask the question, “What is diversification?”  Simply put, the answer is; not putting all your eggs in one basket. It is a technique that helps minimize risk by spreading your assets across different types of investments.  So to the extreme, it is putting each of your eggs into separate baskets.

               Most risk levels (see the Various Types of Risk in the Market post on this blog) can be diversified out.  Ideally, you would want to spread your assets across as wide a range as possible.  Currently, higher costs and complications (int’l taxes, currency exchange fees, etc.) make some of this unfeasible.  It would be hard for the average American who was managing their own portfolio to buy shares of a tire company traded on the Australian exchange, a tea producer on the Hong Kong exchange, a bank traded on the London exchange, etc.  Fortunately, the vast expansion of the internet does allow that person the ability to diversify quite adequately.  Here are some of the arguments and their underlying reasoning:

·         Most finance majors are taught in college that if the stock-price section of the Wall Street Journal is hung on the wall and a blindfolded individual throws darts until ten stocks are hit, that a portfolio (or a basket) of those investments is purchased will perform almost identically to any market index.  Broken down, any ten randomly selected investments will perform up to par with the market.
 

·         Dr. Jim Cramer (host of Mad Money on CNBC) holds a philosophy that a portfolio of five strategically selected stocks will be adequately diversified.  The selected stocks should be chosen from five different sectors/industries and that an evaluation of the fundamentals (or key strength indicators) should be done to select firms that are one of the best-of-breed in their respective industry.  The result is proper diversification and a little additional safety from some firm specific rick elements (bankruptcy, etc.).
 

·         Statistics teaches that an accurate representation of a group (the markets, in this case) can be reach with a random sample (portfolio) size of 30.  Interpreted, a portfolio of 30 randomly selected investments will perform 99.9% similarly to the market.  Our most common market indexes fall into this general category (while ignoring the benefit of random selection).  The S&P500 is a summation of the performance of 500 different stocks.  The Dow Jones Industrial Average is a function of 30 notable industrial stocks.  It is an important note that while the DJIA is an indicator of a broad industrial sector, it also is used to represent the overall health of our domestically traded market.
 

My philosophy is based upon these teachings, my trading style, and the experience I have trading in the market.  I tend to take a more statistical approach when selecting stocks to create a diversified portfolio from.  I generally select 20 stocks for my trading basket.  Why not 30?  While statistical concepts are very well founded, when applied to portfolio selection – the added transaction costs outweigh the benefit of adding the 10 additional stocks.  It costs [me] roughly $10 to buy, and then another $10 to sell a stock in the market.  The benefits of additional diversification from adding the 21^st stock to the basket are outweighed by the transaction fees.  As a fund gets larger, it may indeed become more cost effective to add the additional stock(s), but in reality the effect is minimal.
 

Often, my model will output two stocks within the same sector (example: Coca-Cola and Pepsi).  I generally do not have to be concerned with this happening because I have a basket of 20, not 5.  I will express that each additional stock within the same sector as another exposes the portfolio to more industry/sector risk.  If I get more than three stocks from the same industry, I will dump one out for the next stock suggested by the model.
 

Why not use the random-dart-toss method?  Let’s face it – Any person educated in finance should be able to select better picks than what would result.  Cramer’s “Best-of-Breed” teachings will even help produce a comparably diversified portfolio that will likely produce higher gains than a completely randomly selected portfolio would.  Other factors also make random selection foolish, such as cyclical stocks (to be discussed in another Blog post), current trends or firm specific factors that would raise a red flag in the minds of even the average investor.
 

The lesson to take from all of this is that most of the risk of loss can be minimized for any investor through simple and proper diversification.  However; diversification will not reduce [global] market risk (which can be reduced; See my blog topic on Hedging *Not Yet Posted*).