Replies to post #8830 on A.I.M. Users Bulletin Board (AIMUSERS)

[Conrad]

Hi Undertakr,

You are absolutely right on your statement on diversification and the statement of Warren Buffet hits the nail on the head too:

Diversification is a protection against ignorance. (It) makes very little sense for those who know what they're doing.

In my book The Vortex Method (1998 revised 2002, in Dutch) I more or less say the same thing except I addressed the ignorance(or deviousness) of the financial advisers that would promise their clients a 6 % yield while they would expect to get 8%(Client happy as a pig in shit(most of the time) and will be bringing in more money to get managed to get 8%) . . . Not to mention the Money Manager being happy too for the big fee he is charging for his ignorance). I argued that with (self)-selecting of a small number of high yielding funds(takes work) it would be relatively easy to get typically 20 to 50% yield(or more).

With respect to Risk/Reward issue I exposed the erroneous notion that high yields are to be had from consistently investing in high risk investments. Specifically I argued that high yields are the result of investing in stocks that are intrinsically low risk stocks, as well as intrinsically being good performers. I did not say that finding such stocks is easy, but I referred to Warren Buffet in this argument, more or less this way:

Warren Buffet is one of the best investors in the world not because he is stuffing his money in high risk companies but simply because he has a nose for low risk enterprises that are good performers to boot, or have the potential to be terrific performers with a little managing of the management.

What it comes down to is selecting only winners as a goal. The fact that one wants to select more than one winner is, of course, also a sort of diversification but one of completely different sort. In this type of diversification the stock selection comes first and is the most important thing, and then after that it will be a good thing to diversify the amount of the investments so that the best performer gets a bit more of the dough and that the liquidities get the highest interest possible.

This is the type of diversification that Aptus is talking about: picking stocks and allocating assets via the MPT is a smart sort of diversification because the underlying assumption is that the investor is already a smart investor. If you select 10 companies that will go broke in the next 4 months the MPT approach will not help one iota. For mediocre stocks the MPT may reduce the losses a bit, or marginally increase intrinsically low yields.

Essentially most of us(not the stampeding herd we buy from) will agree that investing blindly in 10 stocks without knowing anything about them is the worst thing that one can do: With a bit of luck he will pick 10 losers . . . the luck being on the seller's side :-). One might as well go to the horse races without knowing anything about the horses that are in the race. One might as well go sailing: that way you get rid of your money faster than investing in Enrons and the like, but at least you might have a bundle of fun.

One more thing on risk(already discussed long ago) is the problem that the real risk attached to an investment is usually completely hidden to the market at large(Enron types) and that the risk people usually kick around in their discussions is a statistical risk based on published price histories. In this sense volatile stocks are usually interpreted as high risk stocks while I claim that such stocks could have very low intrinsic risk instead. A robust solid company could be subjected to specific market factors that give it a volatile character. Such stocks are the gems in the market and especially good for the Vortex Method and for AIMing generally.

In this sense diversification of multiple volatile high yield stocks in an AIM portfolio is also a smart thing to do, especially if the correlation is such that half of the stocks go up while the other half goes down. In this case one would not need any cash at all.

I suppose if I could convince all readers that investing in risky ventures is a bad investment policy then I would be pleased. I am an expert on this: I lost my house on a high risk engineering venture. . . Some people do not like to be converted. . . so it seems.

[aptus]

Hi UT,

Yes, not everyone thinks diversification is a good idea. Some of that stems from the fact that people use the term in a variety of *different* ways.

Mutual funds, for example, are said to be diversified. However as far as I'm concerned, most are over-diversified (especially the large ones) which is almost as bad as not being diversified.

I mean large funds have to be. When you're managing that much money there are only so many companies you can hold before you need to reach down to the second tier, and then the third tier, fourth, fifth and so on. That's not proper diversification.


"The way to limit risk is to limit loss."

That's true, but I don't believe that a stop is the way to do it for an investor (although I completely believe that *traders* should use them).

What happens is that you get stopped out of the stock when the price temporarily goes south. Using AIM and a stop loss doesn't make sense. Using a stop when you have a long term investment horizon also doesn't make sense.


"Diversification also comes with the understanding that you need many stocks to diversify."

I'm not sure what you mean by many, but I think 10 or less should do it. That's not too many in my opinion.


"The first week I posted on this site I mentioned that Warren Buffet was against diversification and everyone lambasted me as being insane."

Well, not everyone. I didn't ;-)


"Diversification is a protection against ignorance. (It) makes very little sense for those who know what they're doing."


First, I think Buffett is using the term in a different way than you think. I mean look at BRKA. It's a conglomerate with interests in fast food, insurance, finance and more. That's as properly diversified a portfolio as I've seen.

However Buffett didn't just go out and pick up a host of companies in the name of diversification. He built his holdings by choosing great, undervalued companies first and then ended up being diversified.

On the other hand, even if Buffett meant he truly doesn't need to be diversified, I believe him. He's Warren Buffett. But that doesn't mean the average (or even above average, actually let's just say everyone except Buffett and a handful of his peers) investor doesn't need to be.

If you follow hockey, you'll know that Bobby Orr was the greatest defenceman to ever play the game. Before Bobby, defencemen never made forays into the offensive zone. Rather they stayed back on defence.

However Orr changed all that by making end to end rushes and scoring more goals than many of the forwards of the era. He was able to do this because he was an exceptional skater and could anticipate when he could go and when he should stay back.

His skating ability and speed allowed him to get back to his defensive position even when he lost the puck in the offensive zone.

At the other end of the spectrum was a defenceman named Dave Babych. Even if you're a hockey fan, you might not have heard of Dave Babych (he played for the Vancouver Canucks).

The reason is that he was as slow as molasses and watching him was anything but exciting. If he decided to make a rush into the other zone (which he never did), I'm sure he'd lose the puck, but if by some miracle he didn't lose it and garnered a shot on net, he wouldn't be able to get back into position quickly enough to do his job. That's the difference between Bobby and Dave.

And while most of us would like to think we're the investment equivalents of Bobby Orr, we're usually really a bunch of Dave Babychs. Whereas a guy like Buffett is a Bobby Orr. So if he thinks he doesn't need to diversify, perhaps he can get away with it. Mere Dave Babychs can't.


"In my opinion, diversification for diversifications sake is a surefire way to not lose as much money, but to slaughter your potential gains. I currently hold 20 stocks..."

If you're saying what I think you're saying here, then I agree. Diversification for the sake of diversification is bad. However proper diversification is not bad. Not diversifying is bad.

The fact that you own 20 stocks (and I'm assuming not all of them were purchased with the aim of diversification) means that you're already diversified. Why not try to determine how to optimally diversify your portfolio with those same stocks? I mean you already have some diversification going there, you might as well make it better.


"This further enforces my view that I should have chosen less stocks."

I'd agree with you that you would be better off with less than 20 stocks.


"put more money in my 'sure bets'"

Now that's the ultimate question. How do you know it's a "sure bet?" And if you do know, then why not put all your money in it rather than just "more" money in it?

My guess is that it's not a "sure bet," rather it's a solid stock with a low probability of going bankrupt. However there's always a chance. To make a long story short (too late, I know ;-) that's why we need to diversify.


"In any event, just my opinion"

I always enjoy reading your opinion.