With a 'moron portfolio', apathy just loves company
T here has long been an argument about diversification. It starts with the rather astounding mathematical revelation and the basis of portfolio optimisation that two risky stocks together are less risky than one risky stock. That is an insight contested by this rather indisputable wisdom: "If you know what you're doing, why would you diversify?"
There has long been an argument about diversification. It starts with the rather astounding mathematical revelation and the basis of portfolio optimisation that two risky stocks together are less risky than one risky stock. That is an insight contested by this rather indisputable wisdom: "If you know what you're doing, why would you diversify?"But the main issue for private investors considering whether to trade individual stocks or buy a diversified portfolio is not about avoiding responsibility but avoiding effort. Diversification is about laziness being endorsed by financial theory. It is about buying enough stocks to dilute the impact of your mistakes. It's about not having to do anything after buying.On a commercial level, it is used as a core sales proposition by managed funds. For a small sum of money you can buy exposure to a lot of stocks. If you go to a financial planner, by the time you leave the office you will have bought 3000 stocks in three different countries and 10 different asset classes.But amid all this risk minimisation no one bothers to explain that, at best, your return is going to be an average of all the averages less fees iced by the inner glow that comes from having kept a lot of BMW dealers in business. There's no transformation in diversification, just a lot of promises and the market return less costs.Now, let's go to the other end of the spectrum. Imagine you had all your money in one stock. Would you be focused? Would you find out everything you could about that company? Would you know more about that company than 99.9 per cent of investors? Would you know what it did? Would you attend its meetings? Would you know the history and background of the chief executive and the board? Would you find out about its industry? Would you be tuned in to anything that might affect it?Would you bounce out of bed to find out what the overnight markets did? Would you micromanage the trade? Would you read books about trading techniques? Would you develop a pyramiding (buying more when it goes up) strategy and a stop-loss strategy? Would you be obsessed?Of course you would, if all your money was in it.In other words, the more risk you take the more engaged you will be with your investments.Compare that with putting all your money in a portfolio of 10 to 20 stocks that were picked because they are big and well known, that you don't really know but are comfortable with because it is a diversified portfolio. What sort of risk management is that?A one-stock portfolio forces you to do everything right, whereas the 10- to 20-stock portfolio of blue chips (the "moron portfolio") breeds complacency and ignorance.On which approach would you rather stake your future? Which one do you think is more risky?The one-stock portfolio is an extreme example but because it substitutes commitment for apathy it is arguably less risky. Ultimately, though, it doesn't matter how many stocks you have as long as you are engaged. Most successful (and unsuccessful) traders will be able to tell you the exact stock they made or lost their money in.But one stock is too few and 20 too many, so traders will tell you to target about five. You'll make more money trading five you know well than you will with 20 stocks you ignore.I used to trade Webjet a lot. Wish I still did. They had/have a strong underlying driver - the growth in online bookings of flights and accommodation. Knowing that was all the risk management you needed. Find stocks that have a strong underlying driver and get to know them. When everyone else is diversifying, finding an edge is just a few interesting hours away.Marcus Padley is a stockbroker with Patersons Securities and the author of newsletter Marcus. His views do not necessarily reflect the views of Patersons.
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