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Diversity, Diversity, Diversity…

That’s what we all want right?

WRONG!

I know it sounds counter-intuitive, but owning a large number of stocks that vary in industry, sector and size can actually hinder your overall performance and leave your returns mimicking those of the overall stock market!

Sure some years that’s a good thing, and others it’s not, but the point is that if you are looking to CRUSH the market and accelerate your wealth creation, you need to stop worrying about diversification, and start looking into gaining an advantage over Wall Street and the overall market forces.

A Quick Note About Diversification

The sad truth is that most folks that invest in individual stocks underperform the market, and lag the indexes by about 2 percentage points a year, according to professors Barber and Odean at the University of California at Berkley (research paper here).

Why?

It’s simple really.

Most people don’t have the time or inclination to do the hard core research necessary to gain an edge over Wall Street and the potential inefficiencies that exist in the marketplace.

So instead of finding hidden companies or those that are severely out of favor and getting to know them intimately, they instead build their portfolios with stocks that they know, have heard of, or have an intimate understanding of, but for all the wrong reasons.

For instance, if someone works for a real estate company, they are more apt to understand the real estate market, banks, construction, etc., than other people who don’t work in these industries.

So someone with this intimate knowledge and expertise, while a boon, can become an albatross when they invest in 2 real estate stocks, 2 banking stocks, and 2 home builders.

Oops…that wasn’t very diversified, or smart was it?

Another reason why the average solo investor loses money to the overall market is because they follow the trends.

Getting into stocks or sectors once they have reached or are about to reach their peaks, and selling other stocks and sectors when they are bottoming out because they can’t take the pain any longer.

Add it all up, and the little guy tends to get screwed when they go it alone.

So, there’s a simple way to cure this: DIVERSIFY!

Well, yes and no.

The Less Diversified the Better

“Wide diversification is only required when investors do not understand what they are doing. ” Warren Buffett

To that point, I want to make a few things clear.

I am not advocating, nor would the great Warren Buffett for that matter, that you put everything you own into 1 stock or company.

However, when it comes to investing in the market and picking stocks, if you truly understand what you are doing, you do not need to own a large basket of stocks, mutual funds and ETF’s in order to remain “diversified”.

Sure, we all know that it’s prudent to own a home, have some money in savings (at least 6 month’s worth), and have some of your money in index tracking funds, etc., etc., but after that, when you get down to it, if you are inclined to pick your own stocks, then you better be prepared to do the work and research necessary to understand what you are doing to the point where you have some type of edge over other investors and Wall Street in general, and then swing for the fences.

Here’s an excerpt from David Jackson that exemplifies what I am saying beautifully taken from an article on Seeking Alpha:

The possibility of consistently beating the market through stock picking - known in the money management business as generating “alpha” - is correlated with the level of market inefficiency. If information is freely and widely available, enough investors are interested, and a stock can be easily and cheaply traded, then all known information is rapidly reflected in the stock’s price. As a result, there is no opportunity for an investor to obtain unique information and thereby beat the market.

On the other hand, if information is not freely or widely available, a stock is relatively illiquid, or investors are uninterested in a stock and fail to act on the available information, then the potential to outperform the market is greater. Where greater information inefficiencies exist, fundamental analysis that uncovers valuable new information can give the stock-picker a real advantage.

A powerful example with my own portfolio is with a company called GeoEye (NASDAQ: GEOY).

Those that have been following this blog for quite some time have read all about, and perhaps even invested in, GeoEye when I advocated we do so.

My investment thesis was predicated on information that, while readily available for those that wanted to do some diligence and digging, was NOT being properly reflected in the stock price.

At the same time, the market was largely ignoring the risk/reward scenario for GeoEye, vastly underestimating the potential of the company’s successful launch of GeoEye-1, as well as its revenue and income generating capabilities.

Thus we could get shares of GeoEye for cheap, and hold on for when our investment thesis finally came to fruition.

As GeoEye’s recent announcement’s have shown, that patience has been well rewarded.

It’s obvious why we need to do research and our homework on the companies that we intend to cover, or get someone else to do it for you that you trust.

For most people, that usually means socking their money away in an index fund or mutual fund, and coming back in 20 years and having a decent if not spectacular return.

But what if you want to beat the market?

What if you want to CRUSH the market?…

You Need to Look Where No One Else is Looking!

Find market inefficiencies and exploit them

Ok, so let’s say you really want to juice up your returns, but aren’t sure how to do that…where do you start?

Simple. You start by thinking SMALL!

That’s right, I mean small cap and micro-cap stocks.

The ones that have the highest inefficiencies of any asset class.

We know that large cap stocks, the ones you have heard of before, are most likely priced “correctly” or will be very soon.

They are written about extensively, have many analysts following them, and are usually priced at exactly what the market will bear taking all that public knowledge into consideration.

Some examples of these types of names include Wal-Mart (NYSE: WMT), Coca-Cola (NASDAQ: COKE), Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), etc.

If you watch these behemoths, with rare exception, you’re lucky if you break even owning them considering the overall returns of the market and the fact that you are losing upside potential when a stock sits in one place.

The same goes, generally speaking but to a slightly lesser extent, to mid-cap stocks.

Only when it comes to micro-cap and small-cap stocks is the average investor with a bent towards research and a highly concentrated portfolio, at an advantage over Wall Street.

Now this isn’t to say that you can’t make a nice chunk of change from a mid-cap or a large-cap stock, they can be mispriced just like any other stock, but the chances of that happening, and not correcting itself rather quickly, outweigh the average investor’s edge over Wall Street.

To further the point, in February 2003, The Wall Street Journal reported that 58% of NASDAQ-listed stocks were covered by one, or no, Wall Street analysts.

This number has fallen even more since then for a variety of reasons that underline the simple fact that Wall Street tends to go where the money flows.

If there is a choice between covering a large company that is likely to do business with that analyst’s firm, or a smaller company that is not as likely to garner them business, you know where Wall Street is going to place their bets.

Of course the large question that you have to ask yourself when you realize these trends is how accurate, and unbiased can these analyst’s research reports and research be if it was done, at least in part, with the intent to make money on the endeavor?

Anyway, back to my point.

Knowing all of this, which stocks do you think are priced with the greatest inefficiencies and give you the most advantage for performance going forward:

  • A large company that has 10 analyst’s covering it that is constantly talked about in the press and media

or

  • A small-cap, or micro-cap company that you’ve NEVER heard of yourself, has no analyst coverage, and is obscure with small trading volumes?

You can see where I’m going here.

The problem for us?

Well, it’s the same problem that Wall Street faces when looking at these companies.

They know little about them, and have to roll up their sleeves and take lots of time and energy to get to know them and find out if they are worth investing in or not.

That’s something that most Wall Street firms are not willing to do, at least not until that company grows larger.

This is precisely our greatest advantage over Wall Street and where the average investor has to look to gain that edge, and ultimately, CRUSH the market!

Finally, as a result of all of the above, it becomes obvious that because it’s hard to find a great company with a great stock price, regardless of the size, it is more likely than not, that your portfolio will in fact become very concentrated as a result!

But the bottom line is that’s it’s much superior to own a small basket of stocks that are researched and well thought out, than own many more stocks just for the sake of being “diversified”.

This also works on the flip side when you find an absolute dog of a company that is poised to go down and are looking to short the stock.

Don’t Limit Your Upside!

Although counterintuitive, less is more

And so I come to my main point: Keep it tight!

By maintaining a portfolio of 5-15 well researched, and highly understood stocks that are severely mispriced by the market you will in turn leverage your time and research far better than if you simply throw in a bunch of stocks just to become more diversified.

I’ll give you a quick example:

Let’s say you had $10,000 to invest and you purchased equal amounts in 5 different stocks that you researched and believed were severely mispriced by the market.

Let’s say (Scenario A) that after 1 year, 2 of the stocks went to $0, 1 stayed about the same, and 2 of them doubled in price.

Example Returns for Diversification Article

Since you invested equally in all 5, guess how much money you have at the end of the year?

Yep, $10,000!

Even under the most dire scenario, where 2 of the companies you picked went totally out of business, and instead of revising your investment thesis and taking a loss, you stuck with them and rode them to the grave, you still didn’t lose anything from your original investment because 2 of your other picks doubled in price and offset your total losses.

But let’s be a little bit more realistic.

What would most likely happen?

You would probably see that your original picks were dogs, sell them for a significant loss, say 50%, and then keep your other stocks.

Under this slightly modified scenario, your returns would then be a little different (Scenario B):

Example Returns for Diversification Article Table B

So with some prudence on your part and knowing when to sell if you are wrong, look what happens to your return for 1 year even with incredible losses.

You gained 20% on your investment in one year!

To put that in perspective, the average market return historically is about 8-10% per year.

If you had say 25 stocks, how do you think the picture would change?

More than likely, your gains and losses would be mostly offset, and even if you did have a couple of stocks that doubled, because your portfolio is so cumbersome, those stocks won’t influence your overall returns enough to greatly impact your gains.

While this is great for limiting your downside risk, it’s also not so great for experiencing long term returns that beat the market.

So, by having a more concentrated portfolio, and even being DEAD WRONG on a couple of your picks, you can essentially CRUSH the market’s returns!

This is where the average investor has a huge edge over Wall Street and mutual funds that cannot own more than a certain percentage of a company for their overall holdings.

By being more concentrated, while much riskier, we also set ourselves up to outperform the market over the long term.

This is how wealth is created.

Don’t Try This at Home Unless…

Lack of preparation will lead to failure

There are some things we need to talk about before you go an take out a second mortgage on your house to invest in a highly concentrated portfolio of stocks in the hopes of becoming the next millionaire!

  • If you can’t stand the heat, don’t start cooking: Micro-cap and small-cap stocks are excruciatingly volatile.

If it bothers you to lose 50% or more of your money in one stock in a very short amount of time, don’t even consider doing this.

  • Be prepared for lots of work: This isn’t rocket science, but it does take a lot of work and dedication.

If you aren’t prepared to spend hours on research, reading company filings, understanding what makes a good company good, following up with your investments daily, and going the extra mile, don’t even get started.

It would be better to let someone else handle the dirty work.

Remember, the results you get will be directly proportional to your knowledge, understanding, and diligence.

  • Be Patient: This is probably the #1 attribute you must have for this type of investing.

It might take YEARS for your investment thesis to play out, but when it does, the stock that you have done your homework on can move quickly.

You could be dead right in your analysis, research and methodologies, but you might look mighty foolish in the short term.

Stocks like these with small floats, volumes and little analyst coverage are like snakes hiding in the grass.

At first no one notices them, then everyone sees them.

By then it’s too late to be invested in them, which is why we have an advantage when first discovering them!

  • Keep it simple: Don’t try to understand every single company under the sun or every sector.

There’s plenty of good research and smart people out there that you can glean information from to help you when you are looking into something new.

  • Keep it tight: Once again, don’t try and purchase every single stock you think looks good.

Stick to the best of the best, and let the rest go.

You aren’t going to be able to research and be intimately familiar with 30 stocks anyway, so don’t even try it.

Instead, get to know 5-10 great companies, and always be on top of every aspect of them, and be ready to pounce when you feel they are ripe for the picking

Bottom Line

A winning approach for long term gains

On this website, I am devoted to finding undiscovered companies and/or those that you may have heard of but that have been thrown in the scrap heap.

I also find those that deserve to be marked down, and are ready to tumble, because I am an equal opportunity investor, and have no problem shorting a company that I feel deserves to be much lower than it is.

It takes a tremendous amount of work and diligence to uncover these hidden gems, and companies that are poised to explode.

That’s why you’ll never see my portfolio contain a huge number of stocks.

This isn’t a stock picking service, rather it’s a market CRUSHING service.

If that means owning 1 stock at a time because I can’t find any others worth owning, then so be it.

If it means I’ve found 15 that are amazing and all deserve a place on your mantle, then that’s the direction we’ll go in as well.

The reality most likely will be something in between.

The bottom line is this:

If you consistently beat the market over time, does it matter how it’s done?

Yea, I didn’t think so.

That’s why you’re here now.

For my expertise and knowledge.

You’re here to beat the market, to crush it, and do it any way possible.

The good news is that so am I!

My money is in every single pick that I recommend on my site.

My goal is to crush the market using my time-tested methodologies and techniques that over time, have proven to be market beaters.

As long as you understand what you are getting yourself into (yes, one of my picks has gone to $0!), then welcome aboard and be prepared for market crushing gains, regardless of the direction in the overall economy or stock market.

Source: A Concentrated Portfolio of 5-15 Stocks Can Crush the Market