Something the Fool Won't Use?

I submitted the following article a week ago but I don't think they will publish it, I hope it is useful.

How Not to Think of diversification

I feel the need to throw in my two cents about an article "How to Think about Diversification." The article talked about being over diversified or under diversified. Too many stocks and you don't benefit if one of them turns out to be a huge winner. Too few and a Merck like blow up has too much of a negative impact. There is truth in that but I disagree with the articles conclusion.

I would start by asking yourself why you invest. What realistic return are you trying to get by owning stocks. We all know the stock market averages 10%-11% per year, right? Well sort of except that the market hardly ever goes up by that exact amount. It is usually a lot more or a lot less.

A properly constructed portfolio will capture most of what the market does, regardless of what stocks you own. Your stock picking ability will determine the extent to which you beat or lag the market.

Owning about ten stocks, as the article suggests, puts too much reliance on your ability to pick stocks and may lead to poor performance and too much trading. The blow up at Merck and the precipitous deterioration at Fannie Mae illustrate the point. The Hennessy Total Return Fund, which owns ten stocks, had a 5.5% weight in Merck and the Sun America Focused Large Cap Value, which owned 25 stocks as of August 31, had a 10.6% weight in Fannie Mae. Neil Hennessy was not smart enough to avoid Merck and David Dreman was not smart enough to avoid Fannie.

If you own only ten stocks you must believe you are as good, or perhaps better, of a stock picker than Messrs. Hennessy and Dreman. Both of these gentlemen clearly know what they are doing. So are you better than these guys? I am not willing to bet that I am.

If you goal for growth is anywhere close to 5%-15% then taking the increased risk of only ten stocks is unnecessary. 30-40 should be sufficient to reduce single stock risk. If that many stocks would eat up too much of your account in commissions you can utilize exchange traded funds in conjunction with individual stocks. This should allow you to keep up with the market and hit your growth target.

One last little nugget, if you can avoid most of the pain of the next big downturn you will put yourself years ahead of your target. "How am I supposed to do" that you might ask? The next time the yield curve inverts, which has historically meant a recessions and a bear market, get very defensive with your portfolio. That worked like a charm in November of 2000.