Sunday, October 10, 2010

Diversifying away your returns

You need only a few (maybe even one) stocks that perform really well for you to get really rich. I can’t tell you which stocks will turn out to be great investments, but what I can tell you is that, if you know what you’re doing, diversification will probably reduce your odds of getting really rich faster than what the returns of the average stock will permit. In fact, I think Warren Buffett said that investors should have a 20 ticket punch card or only make 20 investment decisions in their lifetimes.

If you managed to identify a few stocks that you believe will really generate great returns, you wouldn’t really want to waste all your effort researching those stocks by not betting big and buying other mediocre stocks that will almost certainly reduce the impact the returns of these great stocks might have on your portfolio, would you? True, stocks might not perform the way we might like them to, but that’s a risk of stock picking, which can be reduced by properly analyzing companies we understand.

At the risk of being labeled as captain obvious, let me just say that a 300% gain from one stock in a portfolio of 3 stocks is a 100% gain for the portfolio, but a 300% gain from one stock in a portfolio of 30 stocks is only a 10% gain for the portfolio.  

Another thing that I would like to add is that a lack of diversification and even stocks in general are not risky. I have friends that keep telling me that I should be careful because I could lose money in stocks, that stocks are risky and requires luck. I know they mean well, but I believe that can’t be further from the mark. If you really know how to evaluate stocks, and you buy into companies with good balance sheet strength, healthy earning and growth, and great lasting competitive advantages, there is actually very little risk. The short-term price drops don’t bother me; in fact, I hope that my stock holdings have significant drops in prices, as it will give me the opportunity to buy more.

Sure, there are still risks (one of the risks being my own errors in evaluation) and I might lose money, but I believe I will be tremendously better off in the long-run than if I were to leave all my money in a money market fund earning interest that’s below the long-term rate of inflation, or worst just use up all my money buying stuff that I don’t need. In his book “Beating the Street,” Peter Lynch wrote, “Buy stocks! If this is the only lesson you learn from this book, then writing it will have been worth the trouble.”  

I’m not saying that diversification is bad, and people who don’t know how to analyze stocks should always diversify via an index fund. In fact, you will, in time, become rich if you invest regularly in an index fund and let compounding do the rest of the work. It’s just that investors can get much better returns if they invested significant portions of their net worth in a few great companies at a fair price, assuming of course that they know what they’re doing.

Thank you for reading, and may you always sustain good returns on your portfolio. Take care.