There is a theory of investing that says you must diversify. What does that mean? Quite simply it means that, in the overall, some stocks will rise and some will fall, but hopefully there will be more winners than losers and you will make money.
Some mutual funds have taken this to the extreme. For example, there is a Total Stock Market Index Fund that includes more than 3,000 stocks. This is stretching the limits of diversification.
So does it work? First we must keep in mind that most mutual funds are not short sellers. Selling short is the practice of selling a stock first and then replacing it at a lower price. In other words, you are betting that the stock price will go down. There are some so-called Ultra-short Index Funds, but generally they are not widely used. Hedge funds do trade the short side of the market and are able to profit when we have a bear market like the one in 2008.
Now let's look back at 2008. Stocks across the board fell an average of 40%, with some falling as much as 90%. The fundamental flaw in these diversification theories of investing is that they work well in bull markets like we've seen up to 2007. When a bear market hits the fan, all bets are off and investors are blindsided and suffer enormous losses. Even the highly diversified Vanguard Total Stock Market idx (VTSMX) fell 37% during the past year.
So what to do? Over the years, I've followed a simple rule: "When in doubt, don't." When you don't "feel" right about the market or a particular stock, stand aside.
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Reader Comments (Page 1 of 1)
1-04-2009 @ 11:27AM
Don said...
Well, this article was a bit shallow wasn't it?
Obviously diversification worked this year--it kept you from being overexposed to the 80% and 100% losers. Look at the way Dodge and Cox got hammered by the large exposure to Wachovia.
Diversification into bonds, and especially treasuries made the pain even less acute.
1-04-2009 @ 2:57PM
Iridium said...
The concept of stock diversification is what has destroyed the economy. It has turned Wall Street into nothing more than a casino.
Diversification has created a market where the only purpose for the market's existence is to make money for investors.
The original purpose for stock was for a company to get a loan from other sources rather than a bank. Those that purchased stock took an interest in a company and loaned money if they thought it was a good idea. They were taking a risk for a later reward if the company took off. By purchasing stock in a company you truly cared about what happened to the company.
Through diversification most people do not even know what they are investing in. They no longer care about the everday dealings or what the company is working on. They just care about a piece of paper that says that thier fund went up.
Diversification is great for corporate boards and stock scams. It is how we built the most fraudulent system in the history of the world. As you spread influence over an ever increasing area the ability for individuals to challenge your position decreases. It becomes ever easier to buy influence and manipulate the system.
Corporations are able to grow far larger than a normal free market system would allow because the larger pool of investors allows for a huge loan, coupled with leverage a $500 million corporation could have the purchasing power of tens of billions. This power fuels the takeovers that have left us with a market with almost no competition.
With stocks loss of any purpose, most corporations today have no real need for sellign stock to fund R&D, the market becomes a plaything for the rich. A game that is toyed with in order to steal money from the masses.
Wall Street has lost its purpose and should be shut down. The future of our economy depends on it. Only the resurection of small business can bring the economy back. The corporation that becomes to big to fail is really to big to be kept alive. It is choking the life out of the economy and will kill it with no chance of ever coming back. We will go back to the dark ages unless we act now.