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Diversification Is the Key to Portfolio Management
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significantly. Being in a money market would have saved some of the loss from happening, but staying in the market and riding out the storm would also have helped. Keep in mind that the Standard & Poor s 500 Index and the Dow Industrial Average had a similar track for 2002.
HOW MUCH DIVERSIFICATION IS ENOUGH
How much diversification depends on the experience, time for analysis, and assets available to the investor. Investment advisers can give glib answers: If you have $10,000 to invest, it should be diversified in 10 companies and three different industries. But this won t work well. Even buying round lots of 100 shares as low as $25 would enable an investor to buy the stocks of only four companies, and this would mean adding extra money for fees or commissions. The 10-company rule would create several odd lots of stock. There is no depth to such investing. Remember the axiom from 20: Make Winners Win Big. It would be better to avoid the odd lot situation (less than 100 shares) and begin with diversification into three or four
PART III Strategy
different stocks in three industries. This will still provide safety, and increase the chances of selecting a good winner. Later on either the depth or the breadth of diversification can be increased with additional money to invest. Also, think of the time involved in analyzing and selecting 10 companies. How about the amount of time required to maintain a close watch on the performance of those 10 companies in three industries Most people will allocate some time for stock portfolio, market, and economic analysis, but the last thing they want is for it to become a second job. It should also be noted that too much diversification can dilute performance significantly. In some circumstances an investor would probably be better off in U.S. Treasury securities or insured certificates of deposit (CDs).
MUTUAL FUND DIVERSIFICATION
A growing number of investment articles are now appearing regarding diversification with mutual funds. How many mutual funds are enough Since mutual funds are already diversified, how much more diversification is necessary Some articles will say no more than 10 mutual funds, others no more than five. Several advisers go the intellectual route and say one mutual fund in each asset class. At least one adviser is said to base the decision on how much paperwork an investor can tolerate. Dilution enters into this as well. It s possible that owning too many mutual funds may position an investor at a point of diminishing returns.
ARE THERE OTHER WAYS TO DIVERSIFY
A practical diversification strategy that will protect all of the original capital is to buy U.S. Treasury bonds and use the interest from them to invest in the stock market. If the bonds are held to maturity, the principal is never at risk. Instead it is returned as the bonds reach maturity. Another form of easy diversification is to take half of the money available for investment and buy zero coupon U.S. Treasury securities with a maturity date out far enough to double in value. If the entire stock portfolio goes to zero (which is unlikely, unless highly speculative companies are selected), the investor will retain the principal when the bonds mature. Obviously, there is a high opportunity cost if this unlikely event
Diversification Is the Key to Portfolio Management
occurs. Although both of these approaches have tax implications and some risk, they are valid strategies for investing with lower risk.
IT IS IMPORTANT
Diversification is important in an investment strategy. It can be used to lower the overall risk and increase the chances for better profits. It s important to remember that risk is not eliminated because of diversification. All investing carries some risk; therefore, it is prudent for the investor to be aware of strategies to moderate that danger. This said, diversification of the investment portfolio can be an excellent risk-moderating strategy.
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