Copywritten by Richard Stoyeck in 2006.
Why do some people only invest in one or two stocks? Some people may have 15 stocks, but 50% of their investment assets may be in just one of them. On Wall Street, people who act like this are said to be "concentrating." Some businesses call it "too much of one thing." When this happens in a brokerage firm, it is always seen as dangerous. It is so dangerous that if a brokerage firm uses a concentrated stock position as capital, the market value of the security in question is cut. This means that in any calculation of capital, the full market value of the security is cut by a fixed percentage. In other words, if you focus too much, you don't get the full benefit. You might have margin accounts. As you know, StocksAtBottom.com says that the best way to own stocks is with cash. We think that if you have stocks on margin, you will get sold out on margin. Most of the time, when you buy stock with a margin account, you have to put up cash equal to 50% of the stock's value. You get a margin call if your equity falls below 35%. Now, brokerage firms love it when a client's margin account has 15 or 20 different stocks. Guess what? They love it even more if there are bonds in that account. Why? Because brokerage firms know that investing in stocks is risky. No matter what, something can always go wrong. In either of the two situations, something could go wrong. It's hard to find 15 situations where something goes wrong. That is what diversification is all about. SPREAD OUT THE RISK. It seems to make sense. Some people have between 50 and 100 stocks. This is because they think they need that many to reach the investment goals they set for themselves. At the master's level in business school, you learn that to really be diversified, you need to own close to 14 equity positions. StocksAtBottom.com has found that having 6 to 10 different equity positions is enough to achieve diversification. We know for sure that it's neither one stock nor two stocks. If you own one or two, you will die.
Putting all your eggs in one basket We tell all investors that they should own more than one stock and more than one sector. Own more than one type of investment, like stocks, bonds, real estate, cash, you get the idea. If you only own one type of investment, you will run into trouble. Stocks with broad themes are called "sectors." Energy, Semiconductors, Housing, Auto, Consumer, Airlines, Personal Computers, and Technology in general are some examples. If you own 10 stocks, but they are all in only two sectors, your portfolio is not very diverse. When they go after Ford Motor, General Motors is usually not too far behind. By the way, when a sector is going your way, it's great to own everything in that sector. When everything you own goes up, it's probably the best feeling in the world. On the other hand, there is no worse emotional low than being too focused on a sector that is going down, down, and down every day. Depression can be so bad that it's hard to believe. Another problem is having more than one kind of investment. Stocks are a type of equity investment. You can put your money into real estate or bonds. There are also investments in venture capital, valuable metals, and things like oil and gas. You can get a lot of variety out of your investment strategies by buying different kinds of investments and putting your money into different types of businesses. Let's look at some real-world examples. StocksAtBottom.com thinks that we have already made enough investing mistakes to last a lifetime, so learn from a few of them.
Arrow Electronics is an electronics company. In the early 1980s, it was Christmas week. One of us was a limited partner at Bear Stearns at the time. We were doing very well as stockbrokers. It was a time when clients paid full commissions (there was no discounting), and they would trade 10,000 shares of $50 stocks. At the time, making between $500,000 and $1,000,000 a year wasn't a big deal. We bought a lot of Arrow Electronics, a company on the New York Stock Exchange that makes semiconductors. Things couldn't have been better. Business was great, the future looked good, and everything was going well. We could talk to the company because we were also in charge of the banking side of things. We knew things were going well. On one of those beautiful days before Christmas, when Rockefeller Center is lit up with a 50-foot Christmas tree and New York City is the place to be, the phone rang. "Hello." A quick answer: "There's been a fire at the Tarrytown Hilton Executive Center, and many people have died." "Okay, that's terrible. How does it affect me, and what's for lunch today?" "Buddy, you don't get it," says the voice in a deadpan tone. "What don't I understand?" " Arrow Electronics' whole top management team was in that fire. "All of them, each and every one of them, had been killed by this terrible thing. It was the worst Christmas ever for these hardworking executives' wonderful families. Families never got better, the company never got better in terms of the people who were still there, and it took years for the stock to get better. In just a few days, it fell from $32 per share to $4 per share. This stock's recovery was slow and hard, and it hurt all the way back. Putting all your eggs in one basket is like Arrow Electronics. It shows what it means to own just one stock. No matter how much you know about a company, SAB says that bad things can and do happen. You can't own just one business because the downside risk is too high. TO SPREAD THE RISK, YOU MUST DIFFERENTIATE.
