Diversification in Stock Investing: Why Bother?

Investors hear a lot about diversifying their stock investments.  They are told not to hold too much stock in any one company or any one sector.  They are told that they can increase their investment returns and decrease risk by owning several stocks in different industries.  The larger their stock portfolios, the more diversified they should be by owning more and more stocks.  Some investment advisors suggest up to 20 individual stocks for large portfolios.  Well, I am not an investment advisor.  I say that is hogwash!

First, what is the purpose of diversification? To limit risk of capital loss, of course. Theoretically, owning several different stocks from different sectors should help decrease the possibility of financial loss. But, look at the results of the sectors of the S&P 500 for 2008 which was down 38.49%:

Energy (-35.93%); Materials (-47.05%); Industrials (-41.52%); Consumer Discretionary (-34.73%); Consumer Staples (-17.66%); Health Care (-24.48%); Financials (-56.95%); Information Technology (-43.68%); Telecommunications Services (-33.62%); Utilities (-31.55%)

Diversification did not help one bit. All sectors declined. Even owning an S&P 500 index fund didn’t save you from the carnage. So, the risk of owning several stocks from different industries was not necessarily helpful.

So, if owning different stocks didn’t help at all, what about owning assets from different classes.  We already know that the S&P 500 lost just over 38%.  But how about other assets?  If we look at the iShares ETFs based on asset class indices, we can get a rough idea of performance.

Emerging Markets (-50.2%); US Real Estate (-43.3%); Commodities (-45.8%); High Yield Corporate Bonds (-24.5%); 7-10 Year Treasury Bonds (+13.2%)

Depending upon what you held and how much, you might have done OK last year but only if you were heavily invested in US Treasury Bonds.  Of course, we all know that investors sold everything and moved into Treasuries since they were so concerned for their capital.

Although I wanted to, I avoided use of the term “better way”.  I think it is better, but I don’t want to sound too biased.  Rather, I would prefer to offer some information that may be helpful.  You can take it or leave it.

Currently, my retirement portfolio is invested in just 5 stocks and 1 ETF.  But for most of last year, I just owned 4 stocks.  One of those stocks, DRYS, went from $77.40 per share on 12/31/2007 to $10.66 per share on 12/31/2008.  That is a loss of just over 86%.  Ouch!

Because of my use of puts, I only ended up losing 41.4% on that one particular stock but only 18.2% for all my retirement accounts combined.  That is better than many professional money managers did last year.  I know several who were paying advisors to lose 40% of their retirement funds. 

My biggest problem was that I stayed bullish for too long and my puts were too far out-of-the-money.  But, I did get to the point where my puts all had value and even though the market kept falling, I stopped losing money.

The point is that diversification isn’t the only way to reduce risk.  Had I done a better job of managing, I could have held my loss to about 10%.  But I did learn from the experience and will be ready the next time the market is down 20% or more.  And I won’t be diversified.