The Need for Diversification in the Stock Market

Why is it that some people only buy one or twoworse emotional low. The depression can be
stocks? Others may have 15 stocks but have 50almost unbelievable. There's also the issue of
percent of their investment assets in just one ofowning more than one type of investment. There
those 15 stocks. In Wall Street we refer to thisare equity investments, which are stocks. There
type of behavior as concentration. Some firms callare real estate investments, and bond
it over-concentration. When this happens in ainvestments. There are also venture capital
brokerage firm it is always considered dangerous.investments, precious metals, and others such as
It is so dangerous, in fact, that if the brokerageoil and gas. To a large extent, you achieve
firm is using a concentrated stock position asdiversity in your investment strategies by owning
capital, then the market value of the security indifferent types of investments, as well as
question is given a haircut. This means that the fullinvesting in different sectors. Let's go into a few
market value of the security is chopped by somereal life examples. We at believe we have already
fixed percentage in any capital computation. Inmade the equivalent of a lifetime of investing
other words, if you are over-concentrated, youmistakes, so learn from a few of ours.Arrow
don't get full value. Some of you may haveElectronics It was Christmas week in the early
margin accounts. As you know, advocates cash1980's. One of us was sitting at Bear Stearns as
ownership of stocks. If you own stocks ona limited partner at the time. We were doing very
margin, it is our opinion that you will get sold outwell as stockbrokers. It was the period of full
on margin. Normally in a margin account you putcommissions (no discounting), and clients were
up 50 percent of the value of the stock youdoing 10,000 share trades in $50 dollar stocks.
acquire in cash. If equity falls below 35 percent,Taking home an income of $500,000 to
you get a margin call. Now, brokerage firms love$1,000,000 in a year was no big deal at the time.
it when clients have 15 or 20 different stocks in aWe were loaded up on Arrow Electronics, a NYSE
margin account. If there are some bonds in thatcompany in the semi-conductor sector. Business
account, guess what, they love it even more.was fantastic, the future was bright, and things
Why? Because brokerage firms know that stockscould not have been better. Since we were
represent risky investments. Something caninvolved on the banking side as well, we had an
always go wrong in any one situation. Maybeopen line of communication to the company. We
something can go wrong in any two situations. It'sknew we had a good thing going. The telephone
tough to see something go wrong in 15 situations.rang on one of those beautiful days prior to
That is the essence of diversification. SPREADChristmas when New York City is the place to
THE RISK AROUND. It makes a lot of sense.be, Rockefeller Center all lit up with a 50 foot
Some investors own 50 to 100 stocks. This isChristmas tree and all. "Hello." A harried response,
because they think they need that many to"There's been a fire at the Tarrytown Hilton
achieve the investment goals that they set outExecutive Center, a lot of people are dead."
for themselves. In business school at a master's"Okay, that's terrible, how does it affect me and
degree level they teach you that to achieve trueby the way, what's for lunch today?" "Buddy, you
diversification you need to own somethingdon't understand," the dead pan voice says. "What
approaching 14 equity positions. It has been thedon't I understand?" "The entire executive
experience of that 6 to 10 different equityleadership of Arrow Electronics was in that fire."
positions is sufficient to achieve diversification. TheAll of them, every one of them had been killed
one thing we know for sure is that it's not oneby this monstrous tragedy. It was the worst
stock or two stocks. Own one or two and youChristmas imaginable for the wonderful families of
get killed.Putting all your eggs in one basket Wethis dedicated group of execs. The families never
advise all investors to own several stocks and torecovered, the company never recovered in
own more than one sector. Own more than oneterms of the people that were left, and the stock
type of investment (that means equities, bonds,took years to recover. It plummeted from $32
real estate, cash, you get the picture) or you willper share to $4 per share in a matter of days.
have problems. Sectors refer to stocks withThe recovery was slow and hard, it was agony all
broad themes. Examples are: * Energy *the way back on this particular stock. Arrow
Semi-conductors * Housing * Auto * Consumer *Electronics is an example of putting all your eggs
Airlines * Personal Computers * Technology inin one basket. It is an example of owning just one
general If you own 10 stocks, but they fall intostock. SAB does not care how much you know
only 2 sectors then you really have not achievedabout a company, things can go wrong and do go
diversity in your portfolio. You see, when theywrong. You simply cannot own just one company
come to get Ford Motor, usually General Motors isbecause the risk on the downside is too great.
not that far behind. By the way, it's great on theYOU MUST DIVERSIFY IN ORDER TO SPREAD
upside to own everything in one sector when thatTHE RISK.Copyright 2006 Richard StoyeckRichard
sector is going your way. There's probably not aStoyeck is the publisher of Subscribers get award
greater high in the world than when everythingwinning stock ideas from one of Americas
you own is going up. On the flip side, when youpremiere money managers. Extraodinary track
are overly concentrated in a sector that's headingrecord has generated returns of 36% per year
down, lower and lower every day, there is nofor 6 years.