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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, 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 investments.

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 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:

  • Energy
  • Semi-conductors
  • Housing
  • Auto
  • Consumer
  • Airlines
  • 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 different sectors.

Let's go into a few real life examples. We at 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 tragedy.

    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 particular stock.

    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.

  • Commodore
    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 generating.

    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 options.

    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.

Folks, it tells you one thing. YOU MUST DIVERSIFY IN ORDER TO SPREAD THE RISK.
  • 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 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 floor.

    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.
  • Technology Stocks - The Last 18 Months 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 exception.

The people whose talent we draw upon at 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 investing errors.


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