“Diversification” is a frequently used buzzword in investment management. The idea is that an investment portfolio should contain a wide range of products where the goal is to maximize return and minimize risk. It’s the “don’t put all your eggs in one basket” approach to investing, and in many cases seems to make perfect sense.
But when it comes to successful long-term investing, maybe it doesn’t.
The academic definition of a properly diversified portfolio, in terms of the number of securities one should hold, seems to be defined as within a range of 10-30 individual stocks. Yet, the investment products of today – the ones you would commonly find as choices in your 401(k) retirement plan or 529 college savings plan – often hold more than 100 securities, in some cases more than 500, believe it or not.
In fact, many of these products are designed to actually replicate the overall market indices, such as the S&P500, a collection of 500 holdings.
So, should you care? Well, answer this: If you were building a World Series-caliber baseball team, would you rather pick the best projected player in the league for each position, or just select everybody in the league? While the answer might seem obvious, there is a pervasive belief on Wall Street that there is somehow an immense amount of safety in numbers. In other words, the more stocks you own, the safer your portfolio becomes, theoretically.
But not really.
If you were the owner of that baseball team, would you be satisfied with a team of players that represented the league average? Or would you instead focus on a select group of players that top baseball scouts believe could be eventual all-stars? If you don’t have your answer yet, maybe this will help: The mean batting average of a Major League Baseball player in 2013 was .253. The mean batting average of the players on the 2013 All-Star team? About .301 . . . . a pretty staggering 19% higher.
So let’s pretend a MLB player is a stock (which they kind of are), and you have to choose a portfolio of baseball players before the season begins. And the value of your account at the end of the season is determined by the mean batting average of the players that you select. Now, do you just “diversify” (by today’s standards) and select every player in the league? Or do you select the top 15-20 players that some of the brightest baseball minds anticipate to be perennial All-Stars?
The answer should be obvious – for All-Star teams and your portfolio.
Recently, there have been some studies that throw cold water on today’s definition of diversification. These studies show that a concentration of only a handful of quality stocks – or stocks that have potential for growth – actually can achieve much better results over time with less risk than spreading your investment over hundreds of securities.
But how do you find those quality stocks?
That’s where research comes in. A good financial manager can leverage insight from some of the industry’s most valued analysts about the future of a company or stock, instead of using its record from the past. Too many managers rely almost exclusively on past performance in choosing which stocks to add to a portfolio. But there’s a reason why lawyers insist on that ubiquitous disclaimer – “Past performance is not necessarily indicative of future results” – because it happens to be true.
That’s why it’s more important to look to the future. Think of it like a pilot flying a plane. The pilot doesn’t care about the weather behind him because it has no impact on him or his future. What he cares about is what lies ahead.
A good financial manager is like one of those scouts sitting in the stands at baseball games, checking out the players to see which ones have potential for greatness, as well as the ones who might be starting to age and slow down. They’re not looking so much at how a player is doing today but what his potential is down the road.
A clear and concise method of selecting those players is a must. Concentrating your portfolio on those MVP stocks is what smart investing is all about.
Diversification does not ensure a profit or guarantee against loss. In addition, there is no assurance that a diversified portfolio will outperform a non-diversified portfolio.
Investing in securities is subject to risk and may involve loss of principal. No strategy assures success or guarantees against loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.