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.

Is diversification the way to make money in the stock market? originally appeared on BloggingStocks on Sun, 04 Jan 2009 09:40:00 EST. Please see our terms for use of feeds.

What happens when too much money is chasing too few deals? In the end, the deals stop being such great deals.

A hedge fund might then keep the cash, patiently waiting for the right opportunity. This too has negative consequences though. The low yielding cash hurts the internal rate of return (IRR) creating a drag on the fund, and in turn, the reputation of the managers. Since the fees (1% to 2% of assets) and profit sharing, as much as 20% of the return over some minimum are based on success, time is not on the side of the hedge fund.

There are so many hedge funds in the market place with more being created all the time that the law of averages will reduce most to mediocrity. Like many things in the investment world, be it mutual funds, exchange traded funds (ETFs), closed end funds or analysts opinions, they are all carried to excess.

I would venture to speculate that traditional low fee index funds like Vanguard's S&P 500 fund or Total Stock Market fund will beat 80% of the hedge funds over the course of time, just like they beat 80% of the stock pickers in any given year.

Continue reading Too many hedge funds, too much money

Too many hedge funds, too much money originally appeared on BloggingStocks on Thu, 03 May 2007 15:45:00 EST. Please see our terms for use of feeds.