Diversifying Doesn't Lower Risk, But It Does Lower Potential Gain

[justin]

Here's a great article on investing: (there is sarcasm in that statement)

http://biz.yahoo.com/ibd/051102/corner.html

Choice bits:

-You hear it all the time from market pundits. To reduce risk in the market... it pays to diversify. Decades of IBD market research beg to differ. Diversifying is more likely to hurt your portfolio than to help it

- cleverly constructed table showing how you have higher returns if you pick only winning stocks instead of winners and losers

Thought everyone could use a good laugh.

 

[wabmester]

My, how the investing paradigm has shifted over the last few years. Stock-picking newsletters are trying to defend themselves against the popularity of MPT.

I imagine that the pendulum will swing again some day. I wouldn't be surprised if a lot of the recent strength in small cap was due to all of the new breed of slice/dice investors "tilting" towards small and value.

 

[wildcat]

Anything printed by IBD garbage. To give you an idea of the low quality --- Jim Cramer gets ideas from it

 

[ats5g]

so much bad advice....

You must first find companies with the best sales and profit growth, headed by a dynamic CEO, with breakthrough products and services.

survey says... WRONG... hmmm, I thought it was those boring old value stocks that beat those growth stocks with the best sales and growth [could be wrong though].

Keep things simple. Focus on a handful of leading stocks rather than a broad swath of names and you'll give yourself the best chance to nab strong gains.

If you only need to buy a few stocks, you can narrow your search considerably. A sharper focus allows you to eliminate flawed candidates and find winners more often.

At least it's comforting to know that there are investors out there that are dumber than me. That was a good ad though.

- Alec

 

[thefed]

the OVERALL concept is right, or the statement anyways.

Anything that lowers risk in the market (diversification) will potentially reduce profitibility compared to a non-diversified portfolio. The swings up or down will be reduced.


That being said, it was a very funny article. I betcha thought that someone read that and it made sense to them, so they went ahead and did it.

 

[justin]

But the title of the article gets it wrong - diversification DOES lower risk.

The article's advice is ridiculous - just buy winning stocks, not losers, and you will outperform a balanced portfolio with winners and losers.

Of course you win the most by only buying the winners. If only you could identify the winners with the certainty of the author of that article. The table they have constructed shows the 40% return you'd get by picking the 3 biggest winners. How can you ever pick those 3 winners out of the 15 stocks in the "diversified" portfolio? Oh, I know, subscribe to Investor's Business Daily for hot (day old) stock tips.

 

[wabmester]

the OVERALL concept is right, or the statement anyways.

Anything that lowers risk in the market (diversification) will potentially reduce profitibility compared to a non-diversified portfolio. The swings up or down will be reduced.

Bzzzt.   The entire premise of MPT is that diversification (into multiple asset classes) reduces volatility without reducing returns.

Nobody considers 15 stocks to be diversification.   The article is arguing against a straw-man with bogus logic.

The basic premise of the article is that if you know which stocks are going to be the winners ahead of time, then buying the winners is a better strategy.  

 

[justin]

If only IBD could successfully pick winning lottery tickets in advance.

 

[maddythebeagle]

Selling your laggards quickly gives you more money you can then use to add shares of your top three picks at opportune times, such as base-on-base patterns and pullbacks to the 50-day moving average. As long as you buy smaller lots of shares the further you get from the initial breakout, you can successfully pyramid up when a leading stock shoots to big gains in a healthy market.

makes perfect sense.

 

[justin]

"Keep things simple."

and

"Selling your laggards quickly gives you more money you can then use to add shares of your top three picks at opportune times, such as base-on-base patterns and pullbacks to the 50-day moving average. As long as you buy smaller lots of shares the further you get from the initial breakout, you can successfully pyramid up when a leading stock shoots to big gains in a healthy market."

My brain cannot reconcile those two statements.

 

[thefed]

Bzzzt. The entire premise of MPT is that diversification (into multiple asset classes) reduces volatility without reducing returns.

Nobody considers 15 stocks to be diversification. The article is arguing against a straw-man with bogus logic.

The basic premise of the article is that if you know which stocks are going to be the winners ahead of time, then buying the winners is a better strategy.

what's MPT?

 

[justin]

model portfolio theory; efficient horizon

 

[unclemick]

Yawn

Bernstein's 15 Stock Diversification Myth - memory says(may be wrong) - your odds are one in six of beating the S&P - got enough smarts to pick the right ones?

Many feel they can.

And so the beat goes on.

Heh heh heh

 

[SteveR]

Gee, I always thought that diversification meant having stuff in differnet industries, investment types, and different classes so when one area goes down the whole basket is not dropped. I guess you just have to know ahead of time what areas are never going to drop or know far enough ahead to sell off before it happens while you are watching out for taxes and keeping it simple all at the same time. Sounds about right to me.

Now where did I put that crystal ball?

 

[MikeD]

Remember: "It's a stock picker's market." and in real estate "It's a good time to sell."

Mike D.

 

[Dry Socks]

I plan on buying stocks that are going to go up.
If they're not going to go up, I won't buy them.

 

[73ss454]

DrySocks,

Sounds like a great plan. Not sure, but seems to me that most people would want to do the same thing.

 

[Spanky]

Buy Google - it's still up.

How about FOXH?

 

[azanon]

But the title of the article gets it wrong - diversification DOES lower risk.

No it doesn't.  It lowers volatility.   

"Risk" means different things to different people.  Diversification increases the risk that you'll have a lower potential maximum return.  It also increases the risk you'll have a mediocre return. 

If i hypothetically set up my portfolio with 100% US treasuries, then i have a very high degree of risk that my rate of return will be lower than that of someone with 100% stock.  A 100% US treasury portfolio would also greatly increase my risk for not being able to keep up with, much less surpassing, inflation. (Discussing risk with this example, not diversification)

 

[azanon]

My definition of diversification:   A method to guarantee you'll have mediocre returns.

Where do i sign up!?!

......

Diversification is for the ignorant (not stupid) masses that do their respective jobs well, but dont know nor care how to invest their money. They just what to know that its being invested in a reasonably responsible manner, and dont want to have to fool with it much. I'm sure everyone of you work, or have worked, with these kind of people. Its most people actually. It is an excellent investment approach for an ameteur.

 

[justin]

Diversification is for the ignorant (not stupid) masses that do their respective jobs well, but dont know nor care how to invest their money. They just what to know that its being invested in a reasonably responsible manner, and dont want to have to fool with it much. I'm sure everyone of you work, or have worked, with these kind of people. Its most people actually. It is an excellent investment approach for an ameteur.

I would find the word "ignorant" not representative of the managers of certain multi-billion dollar portfolios that are diversified and passively managed.

 

[justin]

Thought I'd add the link to vanguard diehard's discussion of this same article. Looks like it is getting similar rave reviews over there.

http://tinyurl.com/bk3w7

 

[Gone4Good]

No it doesn't.  It lowers volatility.   

Never seen a well diversified portfolio drop to zero before.

 

[Gone4Good]

If i hypothetically set up my portfolio with 100% US treasuries, then i have a very high degree of risk that my rate of return will be lower than that of someone with 100% stock.  A 100% US treasury portfolio would also greatly increase my risk for not being able to keep up with, much less surpassing, inflation. (Discussing risk with this example, not diversification)

A portfolio with 100% treasuries isn't really diversified, now is it?

 

[lazyday]

Diversification increases the risk that you'll have a lower potential maximum return. It also increases the risk you'll have a mediocre return.

R Gibson makes good arguments for diversification reducing not just volatility but risk, and increasing return. There's a short article on the web somewhere, perhaps at MSN, and a very good book called Asset Allocation, Balancing Financial Risk. I strongly recommend the long version of the book, not the little one intended for a financial advisers.