The Need for Stock Market Diversification
Why is it that some
people only buy one or two stocks? Others may have 15 stocks but have 50
percent of their investment assets in just one of those 15 stocks. In
Wall Street we refer to this type of behavior as concentration. Some
firms call it over-concentration. When this happens in a brokerage firm
it is always considered dangerous. It is so dangerous, in fact, that if
the brokerage firm is using a concentrated stock position as capital,
then the market value of the security in question is given a haircut.
This means that the full market value of the security is chopped by some
fixed percentage in any capital computation. In other words, if you are
over-concentrated, you don't get full value.
Some of you may have margin accounts. As you know,
valuestockplayers.com advocates cash ownership of stocks. If you own
stocks on margin, it is our opinion that you will get sold out on
margin. Normally in a margin account you put up 50 percent of the
value of the stock you acquire in cash. If equity falls below 35
percent, you get a margin call. Now, brokerage firms love it when
clients have 15 or 20 different stocks in a margin account. If there
are some bonds in that account, guess what, they love it even more.
Why? Because brokerage firms know that stocks represent risky
Something can always go wrong in any one situation. Maybe something
can go wrong in any two situations. It's tough to see something go
wrong in 15 situations. That is the essence of diversification. SPREAD
THE RISK AROUND. It makes a lot of sense. Some investors own 50 to 100
stocks. This is because they think they need that many to achieve the
investment goals that they set out for themselves.
In business school at a master's degree level they teach you that
to achieve true diversification you need to own something approaching
14 equity positions. It has been the experience of valuestockplayers.com
that 6 to 10 different equity positions is sufficient to achieve
diversification. The one thing we know for sure is that it's not one
stock or two stocks. Own one or two and you get killed.
Putting all your eggs in one basket
We advise all investors to own several stocks and to own more than
one sector. Own more than one type of investment (that means equities,
bonds, real estate, cash, you get the picture) or you will have
problems. Sectors refer to stocks with broad themes. Examples are:
- Personal Computers
- Technology in general
If you own 10 stocks, but they fall into only 2 sectors then you
really have not achieved diversity in your portfolio. You see, when they
come to get Ford Motor, usually General Motors is not that far behind.
By the way, it's great on the upside to own everything in one sector
when that sector is going your way. There's probably not a greater high
in the world than when everything you own is going up. On the flip side,
when you are overly concentrated in a sector that's heading down, lower
and lower every day, there is no worse emotional low. The depression can
be almost unbelievable.
There's also the issue of owning more than one type of investment.
There are equity investments, which are stocks. There are real estate
investments, and bond investments. There are also venture capital
investments, precious metals, and others such as oil and gas. To a
large extent, you achieve diversity in your investment strategies by
owning different types of investments, as well as investing in
Let's go into a few real life examples. We at valuestockplayers.com
believe we have already made the equivalent of a lifetime of investing
mistakes, so learn from a few of ours.
- Arrow Electronics
It was Christmas week in the early
1980's. One of us was sitting at Bear Stearns as a limited partner
at the time. We were doing very well as stockbrokers. It was the
period of full commissions (no discounting), and clients were doing
10,000 share trades in $50 dollar stocks. Taking home an income of
$500,000 to $1,000,000 in a year was no big deal at the time.
We were loaded up on Arrow Electronics, a NYSE company in the
semi-conductor sector. Business was fantastic, the future was
bright, and things could not have been better. Since we were
involved on the banking side as well, we had an open line of
communication to the company. We knew we had a good thing going.
The telephone rang on one of those beautiful days prior to
Christmas when New York City is the place to be, Rockefeller
Center all lit up with a 50 foot Christmas tree and all. "Hello."
A harried response, "There's been a fire at the Tarrytown
Hilton Executive Center, a lot of people are dead." "Okay,
that's terrible, how does it affect me and by the way, what's for
lunch today?" "Buddy, you don't understand," the
dead pan voice says. "What don't I understand?" "The
entire executive leadership of Arrow Electronics was in that fire."
All of them, every one of them had been killed by this monstrous
It was the worst Christmas imaginable for the wonderful
families of this dedicated group of execs. The families never
recovered, the company never recovered in terms of the people that
were left, and the stock took years to recover. It plummeted from
$32 per share to $4 per share in a matter of days. The recovery
was slow and hard, it was agony all the way back on this
Arrow Electronics is an example of putting all your eggs in one
basket. It is an example of owning just one stock. VSP does not
care how much you know about a company, things can go wrong and do
go wrong. You simply cannot own just one company because the risk
on the downside is too great. YOU MUST DIVERSIFY IN ORDER TO
SPREAD THE RISK.
Folks, it tells you one thing. YOU MUST DIVERSIFY IN ORDER TO
SPREAD THE RISK.
The years were 1983 and 1984. To quote
Frank Sinatra, "It was a very good year. We'd ride in
limousines. Their chauffeurs would drive, when I was 35." One
of us at VSP was involved with a stock called Commodore. They were
setting the world on fire. Commodore was a barnburner. They were
leading the personal computer revolution in this country with a
small computer that would fit on your desktop. They literally could
not make these things fast enough for the demand that the public was
The Chairman of the company had hundreds of millions of dollars
in stock. If this play were going on today we'd be talking $10 to
$50 billion in market value, but it was a different age. Same
story, different names as they say. Some of us used to fly around
with him in a corporate jet (maybe he owned it himself, he was
rich enough) to an island in the Caribbean where he owned a huge
estate. The island was a big tourist attraction with two parts and
a connecting toll bridge in the middle. One day while flying over
the island he mused casually, "Hey, do you see that toll
bridge? I own it." The guy was collecting a toll on everybody
that wanted to get from one side of the island to the other. It
was a great deal.
We knew the next model of their computer was coming out on the
Commodore line. Only the heavens know how this company was able to
keep manufacturing these products in the quantities that were
required. We are talking millions of units.
The President of the company, his name was Jack Tramiel, was a
real operations guy who had survived the death camps in Germany
during an incarceration of several years. One thing is probably
for certain on this planet: anybody who can make it through a
concentration camp for several years really can't have too much
bother him after that. It kind of puts business problems into
perspective. What's the significance of a malfunctioning
semiconductor chip in the grand scheme of things anyway?
You've got to understand, the boys in the firm were trading
Commodore on a daily basis, buying and selling millions of shares.
The firm probably owned the options market in the stock. This was
big time stuff, millions were being made. One day we heard that
the company might be bought out by RCA, now gone as a stock, but
back then RCA was a household name. We put millions into the
Okay, now the good stuff, or should it be bad stuff? A couple
of us are skiing on one of the great mountains of the world, and
it hits the fan. It's bad news everywhere, the President who
survived the Nazi death camps has operating problems that he's not
supposed to have, and he's got problems dealing with the problems.
He immediately resigns in disgust. The next guy in line can't
figure out what to do, and our group is left to hang out in the
cold wishing we could be by the toll bridge in the Caribbean.
One member of our group lost a fortune on Commodore. We won't
tell you which one, but he's typing these words that you are
reading. Come on, what more did you need to know? We knew the
industry cold. We knew the management cold. We knew the operating
fundamentals cold. We had a telephone tie-in to the Chairman of
the company. It was a lay-up that wasn't so laid up.
- Oil stocks 1979-1981
A couple of us were involved in
the oil stocks in the late 1970's, early 1980's. It was a period of
oil shortage on a worldwide basis. The stocks were flying. It was a
very similar period to the technology boom of the last few years.
Stocks with no past and no future were trading to astronomical
valuations. Sound familiar to you? We've been through it scores of
times. The name of the industry changes, but the way it turns out in
the end is always the same.
It's like the Harvard professor that lectured on financial
statement analysis that loved Cisco Systems at $80something. He
lost all objectivity. He thought it was going to $150. It's funny,
but everybody on the planet that owned Cisco at $80something
thought it was going to $100 plus. No body thought it was going
below $20, except maybe valuestockplayers.com. We are documented as
saying as much on this site. Look it up; it was a once in a decade
call that proved to be prophetic. Back to the oil stocks.
One of the stocks that a group of us liked was a company called
Nucorp Energy. The inside scoop was coming from a partner at
Lehman Brothers who was the investment banker for this company.
The partner shall remain nameless. He knew more about Nucorp than
you know about your own family history. He was smooth, handsome,
erudite (nice word, look it up), a brilliant analyst and a gifted
dealmaker. Fred had it all.
One day about two years into our relationship he layed out a
story why this stock is going to explode on the upside. This was
20 years ago; we sat there mesmerized (another nice word, named
after Mesmer, the famous hypnotist in the 19th century), "Yea
Fred, you think so?" "Yes sir, I think so!" Fred
was certain. The stock is trading at $14 per share and we buy the
hell out of it. At the time a group of us were big time players at
Bear Stearns and company. We had partner relationships on the
trading floor. This meant we could go to the finest investment
professionals in the world by simply walking onto the trading
We remember going onto the floor to see a partner named Bob and
casually asking, "Hey Bob, what's the story on Nucorp Energy."
Bob says, "Don't know it, but I've got a client who's
Chairman of Dover Corporation. They are in the same business. I'll
call him and find out what the story is."
Now Nucorp was in the oil pipe business. Fred's big story was
that they had $300 million in demand and could not satisfy it
because business was so good that they could not keep up with
demand. Remember, the stock was $14 per share. When we went to our
partner friend Bob at Bear Stearns, the stock was $131/2 per
share. Bob got the Chairman of Dover on the line, a direct
competitor of Nucorp, and asked him about Nucorp. His response was
quick and to the point, "I don't know about Nucorp's
business, but I've got $100 million in pipe and nobody to sell it
to." We knew we'd been had, or somebody had been had. We sold
every share of Nucorp we owned, taking losses all the way down to
$12 per share. Within 6 months the company announced a bankruptcy.
There are three points to this story. They are:
- 1) Make sure you do enough homework to know what you know to
be true is true.
2) Fred is now one of the three most
important people in one of the world's most important investment
companies. Living proof that fools do get promoted.
yes, YOU MUST DIVERSIFY IN ORDER TO SPREAD THE RISK.
- Technology Stocks - The Last 18 Months
valuestockplayers.com does not care which ones you owned: if you were
heavily weighted in technology stocks over the last 18 months, you
took a bath. It's pure and simple. Some 18 months ago technology
stocks represented over 36 percent of the Standard & Poor's 500
Survey. That number is now 17 percent. This means that the average
technology stock lost half its market value.
It was one of the worst blood baths in financial history. Over
4 trillion dollars in market value was eradicated. It's not over
yet, by the way. Many of these stocks are still in the process of
bottoming. You won't learn this from analysts. They are unduly
optimistic and are biased to the upside. Take a quick example.
Recently, Delta Airlines announced that they are changing the
fleet of planes that they are using on the Boston to New York, and
New York to Washington DC shuttle flights. This is the most
profitable airline route in the country, and there are two
airlines that share it. One flies every hour on the hour, and the
other flies every hour on the half-hour. Delta was using a plane
that had 150 seats on it, but they are going to a plane that holds
less than 50 seats. They didn't even specify why, but it's
obvious; it's an absence of demand. Now, VSP has to tell you that
Delta is only doing this because demand is collapsing. So who is
not buying tickets? It's not young mothers with children traveling
from New York to DC to visit the zoo. It's businessmen whose
businesses revenues are collapsing. That's how you know the
recession is still on.
The conclusions are simple. Things can
always go wrong. The Watergate break-in was supposed to be a simple
affair. The Bay of Pigs was supposed to take just a few days to topple
Castro. Viet Nam was supposed to be a limited engagement. In 1969, then
President Nixon began a war on Cancer. It's still around. Things do not
always go according to plan. In Wall Street diversification is your
friend. Take care of your friends and diversify. There is safety in
numbers. Owning several stocks will help you protect yourself, which
means protecting your money. Don't own just one industry. Keep some
money in cash. Never, ever buy on margin, unless you are perfectly
willing to lose everything. Margin always kills the investor, without
The people whose talent we draw upon at valuestockplayers.com have
been in this business 30 years. As far as diversification goes, we do
know what we are talking about. VSP speaks from experience. Remember
the words of Santayana, the Harvard historian, "Those who do not
learn from history are doomed to repeat it." Learn from the
costly investment mistakes of our professional histories so that you
won't have to pay the high tuition it will cost to learn from your own
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