There is a popular radio investment program that plays a game called “Am I diversified?” in which callers give five stocks and the host response with his opinion if they are diversified. I appreciate the entertainment value of game, but the educational value is highly suspect for the following four reasons:
1. US Stocks are only one of six major asset allocation categories we use. To ignore the other five categories is to fail to be diversified. All six major asset allocation categories are 1) Short Money 2) US Bonds 3) Foreign Bonds 4) US Stocks, 5) Foreign Stocks 6) Hard Asset Stocks. Occasionally a caller will include Exxon-Mobile (XOM), which is a hard asset stock. Aside from this, everything suggested is US stocks. By definition, you can’t be diversified picking 5 investments all in one asset class.
2. Diversification means that your investments are not tied to the movement and fortunes of individual stocks or industries. Our rule is that no individual stock should represent over 5% of the portfolio’s total value. This means that, at a minimum, twenty stocks are required to diversify a portfolio. Beyond 15% of your portfolio being in an individual stock the risk increases dramatically without any increase in the average return. You can do the math. Five stocks means that each stock represents about 20% of the portfolio’s net worth. By definition, you can’t be diversified with only 5 stocks.
3. Within each major asset class your portfolio should be diversified. Within US stocks, we diversify a portfolio between various levels of capitalization. A stock’s capitalization can be computed by taking the outstanding shares times the share price to compute the total value of all the outstanding shares. If the value is over $5 billion it is consider a Large-Cap stock. Between $1 and $5 billion is considered Mid-Cap, and below $1 billion is Small-Cap. Mid-Cap and Small-Cap investments will do better than Large-Cap in certain economic environments (such as the current one). If you recognize the company’s name, it is probably Large-Cap. So far, all the callers I have heard have pick 5 Large-Cap stocks. By definition, you can’t be diversified by picking all Large-Cap stocks.
4. Admittedly, the whole point of the game is to pick 5 stocks from different industries. We have multiple tools that divide stocks into many different industries, and that “see-through” mutual funds to examine the industries of the individual stocks held by those mutual funds. We use these tools to look at the industry diversification of our client’s portfolios and also attempt to over-weight those industries that should do well in the current economic environment. The highest-level aggregation of industry categories in any of these tools has 12 different industry categories. In my estimation the entire radio game, “Am I diversified?” boils down to picking 5 stocks, each in a different one of the 12 highest-level industry categories. This can be accomplished 38% of the time by accident simply by picking 5 random stocks. But again, by definition, you can’t be well-diversified picking only 5 out of 12 industry categories.
I’ve learned that while everyone agrees that you should be diversified, it is important to know what your manager means by the term “diversified.”
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