When is It Time to Diversify Your Investments?

Posted on the 13 January 2014 by Smallivy

Longtime readers of The Small Investor will know that the investment strategy doesn’t fit with the typical advice.  Most investment advisers would advocate for a large amount of diversification right from the start.  Good ones would advise using a set of low cost index funds or Exchange Traded Funds to achieve this diversification.  Poor ones would recommend a set of high load, heavily managed funds that would take a 5% sales charge right off the bat.

The strategy presented here of concentrating in a few larger positions is designed to keep costs extremely low and utilize the individual investor’s advantages.  These are the ability to concentrate in the best stocks in each industry and to reduce costs through longterm investing.  Rather than buying stocks, the investor is investing in businesses and allowing his money to grow with them.

Early in his career, the individual seeking to be financially independent would be living on less than he made and putting money away regularly for investing. Because he had relatively little to invest, he had little to lose. This, combined with a long time horizon that allowed for recovery from mistakes and just plain-old bad luck meant that he could be more aggressive with his stock investments than could someone who was using the money to provide day-to-day income.

Remember also we’re only talking about investments beyond traditional retirement plans.  He would also be putting money away regularly in his work’s 401K plan and perhaps a personal IRA on the side.  The IRA might also have some individual stock holdings, but the 401k should be all in mutual funds, as should a portion of the IRA.  This would ensure that even if his individual stock investments didn’t work out, he would still have a retirement equivalent to his peers. Actually, better than most since many of his peers would not contribute to their 401K’s and IRAs or cash them out at some point in their lives once the balance started building up.

Being aggressive did not mean being foolish.  He would still invest in a way that would put the odds in his favor.  This included investing for the long-term where growth in a stock’s price could be expected to follow the growth in intrinsic value of the stock he was buying.  Likewise, he would be buying shares only in companies with steady earnings growth, good management, and room for continued business growth.  He wouldn’t be trying to time the market or playing various investing “games” since he knew that the odds in those games were stacked against him.

The risk he would be taking was concentrating his holdings in a few great stocks rather than spreading his money out over dozens of stocks or buying an index or mutual fund and just accepting market returns.  He would be concentrating his investments in a few companies that he believed would outperform their peers over the long-term.  Because bad things happen to even good companies — officers steal money or cook the books, new regulations are created that hamper the business, competition emerges that takes a large amount of the company’s market share, or they drill a hole in the bottom of the ocean and kill everything in the area, he would be taking the risk that one of his selections could decline substantially in value.  He would know that the price of the shares of any individual company can decrease rapidly or even become worthless in a short amount of time and take that risk into account.

However, while the entire market does not increase in value that rapidly, averaging about 10% per year, it is not that uncommon for individual stocks to double or even quadruple in the period of a year.  If one is fairly good at picking stocks, one can therefore make up for one or two bad stocks that go nowhere or even disappear  with one great stock that goes up twenty-fold over a period of 10-20 years.  In the early stages, our young investor is trying to find one of these stocks to make his meager holding grow rapidly.

As this investor continues to buy shares, however, he should reach a point where he does start to have enough money to begin to protect it.  In his personal investment account, he may have 5 of 6 large positions worth about $10,000-$20,000 each, with an account balance of fifty to one hundred thousand dollars.  (Note, he should also have a like amount in a 401k by that point if he was putting away 10-15% of his paycheck, which would be invested in an array of mutual funds.)  At that point he should start diversifying his holdings to reduce risk. As stated before, diversification reduces risk because holding a basket of stocks or other investments reduces the damage done by the collapse of any one asset.  Even if a company doesn’t fail outright, the advances by some stocks in the portfolio will offset the losses or stagnation in other stocks.

One strategy would be to have a set of go-to index funds or index ETFs to use for diversification.  Once an individual holding starts to be so large that a loss would be a major setback, some shares would be sold to trim the position and used to buy shares of the index fund.  With some successes, soon the shares of the mutual funds would exceed the amount the individual originally invested, meaning that even if the entire stock position was lost the investor would at least have what he invested.  Keep this up, and as time passes the percentage invested in individual stocks would naturally shrink and the and percentage in mutual funds would grow even though the actual amount invested in individual stocks would remain about the same.

Contact me at [email protected], or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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