In the June 10th post, I wrote about the dangers of buying stocks in companies you think you know well, and I extolled the virtues of diversification.  One reader posted a comment saying that he believed that owning 30 to 35 individual stocks was “sufficient” diversification.   I’m not so sure.

Today’s Hot Tip: Don’t Buy Stocks! an article by Howard Gold, written in 2008, reinforces my arguments.  He interviewed several professionals to make his point.  Here is a summary of his article.

William Bernstein, a money manager and the author “estimates that because of close correlations between markets, even 100 carefully chosen stocks can’t match the diversification of holding just a couple of index funds and ETFs that cover the global market.”

If you’re still not convinced, just how much work are you willing to put into picking stocks?

According to Gold, “even individuals who have good stock-picking skills rarely can do the necessary research to post consistently good results over time.”

He quotes a study by the Schwab Center that “tracked the portfolios of Schwab clients who had $5,000 in household equity and whose accounts were either at least 95% individual stocks (including foreign shares and ETFs) or 95% open-end equity mutual funds.

The survey, taken over 2005-2006, produced stunning results:

The fund investors substantially outperformed the stock pickers, with less than half the risk and after all expenses.

Though it covered only two years—and the investors may have held other assets at other financial institutions—it did take in a huge number of the 3.5 million clients of Charles Schwab, about as good a sample of the US investing public as you can find.”

Doing Your Homework

“You have to have tremendous energy to devote to the stock-picking process,” says David Swensen, chief investment officer of Yale University. “Individuals don’t have the time or the resources.”

In his book “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen advises individuals to stick to a set of broadly diversified index funds.

“If you try to manage your own money and invest in your own stocks, and you don’t…do every single piece of homework necessary, you won’t beat the market, and you’ll probably lose money,” says one well-known investing guru.  “If you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks.”  (Emphais added.)

Who said that?  Vanguard founder John Bogle?  No, it’s Jim Cramer, who pounds the table for individual stocks amid the booyahs and silly hats on his weekday Mad Money show on CNBC.

“Investing is fun for a lot of people, and if they want to try their hands [at stock picking], they should go for it,” says Peterson. “Just make sure that the majority of your portfolio is diversified.”

Gold’s observation is that the rest of us should “get our thrills and chills elsewhere.”

Conclusion

You can only achieve real diversification by investing in both stocks and bonds.  Moreover, within each category, you need to have many individual securities to be truly diversified.

Suppose you believe that your portfolio should include the following asset classes: large-cap U.S. stocks, small-cap U.S. stocks, large-cap international stocks, small-cap international stocks, stocks from emerging markets, and Real Estate Investment Trusts.  How can you possibly achieve this diversification without hundreds of individual securities?  In my opinion, you can’t, which is why you need mutual funds.

The portfolios I construct for my clients typically have mutual funds with thousands of securities.  That is diversification.

What I want to do is save you from the potential losses caused by buying individual stocks.  Sadly, this is not merely an academic discussion, since I have known many people who have been crushed by losses in individual stocks.  It upsets me to know that the devastation could have been avoided.

Buying individual stocks certainly gives you something to talk about over drinks with your friends.  But I don’t believe that the cocktail chatter advantage means you should actually buy individual stocks.  I don’t invest in individual stocks for myself, and I don’t recommend it for my clients.

People always have their reasons as to why their favorite stock is just “great.”  Some have done their research and have created a model that predicts that the stock that they are going to buy will double in the next four years.  Others have been following the same company for decades and are convinced that now is the time to buy.

Usually they’re talking about well known companies, such as General Electric, Johnson & Johnson or General Motors.  Did I get you?  I made that last one up.  In actuality, no one has ever told me that he was planning to buy General Motors.  That’s good, because looking back, we now know that GM, even though it was once considered a solid “blue chip” stock, was not in fact such a smart investment .

And there’s the rub. Looking back, it is crystal clear that we should’ve bought Microsoft when it first went public.  We should’ve bought Google.  Anyone with the time and inclination can do the research and figure out which stocks they should’ve bought.  But it’s not so easy going forward.

For one thing, there’s an excellent chance that whatever you have learned that convinced you that a particular stock is a good buy is already known by everyone else.  Therefore, the current price already reflects the brilliant insights you so cherish.  But another reason is that stocks are inherently risky.  If you are not using mutual funds to achieve diversification, but only buying a few stocks, you’re adding to your risk, unnecessarily.

Chances are you’re buying the stock of a company that you know quite well. If you live in Seattle there’s a good chance that Microsoft and Starbucks are in your portfolio.  Great.  And if you live in Rochester, New York there’s an excellent chance that you had Eastman Kodak and Xerox in your portfolio. Not so great, we now know.

In Atlanta, many people have invested in Coca-Cola.  By the same token, people in Houston had invested in Enron.  Where you live, and what you are familiar with, are not good reasons for investing.

Neither is loyalty.  Maybe your grandfather gave you some stock before he died and told you never to sell it.  I’m sorry, and I mean no disrespect, but don’t listen.  That stock with a family pedigree could be the next General Motors.

Or maybe you used to work for a great company and you have accumulated a lot of stock in your former employer.  But were you lucky enough to have worked for Exxon or unlucky enough to have worked for Citigroup or Bear Stearns?  Why let luck play such an important factor in your investment success?

By now you get the idea.  I’ve probably been way too repetitive.  But this is a really important concept.

As Nick Murray, author of Simple Wealth, Inevitable Wealth, says “Diversification is the conscious decision never to be able to make a killing, in return for the priceless blessing of never getting killed.”

To be continued.

“Overconfidence is probably the most important of financial behavioral errors.” – William Bernstein.

Familiarity Leads to Concentration

A recent article, Why It’s Wrong to Hold Too Much of One Stock by Jilian Mincer, of The Wall Street Journal, explains that “individuals frequently overinvest in local companies.”

They think they’re reducing risk and optimizing gains by following the adage, ’Invest in that you know.’ Yet too much concentration in one stock actually increases risk as a lot of investors in Home Depot, Starbucks and Washington Mutual have discovered.

“It is a well-known phenomenon,” says Stuart Ritter, a financial adviser at T. Rowe Price Group Inc. in Baltimore, Md. “We think we know more about things that we’re familiar with.”

David Hirshleifer, a finance professor at the Paul Merage School of Business at the University of California, Irvine, says people have a natural tendency to like things with which they’re familiar.

“We treat things we’re used to as friends,” he says. As a result, investors buy local stock and donate to local charities. That same sense of familiarity also encourages people to invest too much in their own countries rather than to build an international portfolio.

Why is this a problem?

Conflict Between Concentration and Prudent Portfolio Management

When the stock market declines, we typically advise “stay the course.” Buy-and-hold is a sensible strategy for the long-term. But that applies to a well-diversified portfolio; it doesn’t apply to any single stock.

The reason is that a lot can go wrong with a single company, and it can happen very quickly. Any individual company or sector is subject to steep declines.

Weston J. Wellington of Dimensional Fund Advisors observes

“Recent events have provided an unusually harsh lesson of the importance of diversification. In a matter of days, shareholders of three financial giants—Fannie Mae, Freddie Mac, and Lehman Brothers Holdings—have seen their shares plunge into the penny-stock category. A fourth, American International Group, is scrambling for survival. “

Fannie Mae was once characterized by Money magazine as “America’s Safest Stock,” with a bulletproof business model that was “as close as you’ll get to an invincible earnings machine.”

Other “impregnable” companies include Pan Am (the premier airline of its day) Enron, “the smartest men in the room” Worldcom, etc. They went from brilliant to bust.

In the past, there have been many companies that once were considered powerhouses, but no longer are. For many years, General Motors was considered the bluest of the blue chip stocks. While GM has not gone out of business, having a concentrated position in its stock would have hurt your portfolio performance tremendously.

To be continued…