Is Diversification Overrated?

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Includes: AAPL, C, CSCO, F, GE, GOOG, SPY
by: SteadyOptions

On CNBC's Mad Money, Jim Cramer has a segment called "Am I Diversified?". A caller tells Jim about five stocks in his or her portfolio and Jim has to decide if the caller's portfolio is "diversified."

According to Investopedia, diversification is "A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated."

According to Warren Buffet, "Put all your eggs in one basket and then watch that basket very carefully. Diversification is Protection against Ignorance" - which means that you diversify when you are not sufficiently confident to bet on which asset (or asset class) will do well and which will do poorly.

According to Mark Cuban, "Portfolio diversification is for idiots. You can't diversify enough to know what you're doing. You've got to do your homework and play your best bets"

According to Jason Sweig, "For anyone with a sustainable ability to identify the hottest investment of the moment, diversification is a mistake. But if you really believe you've got that ability, you're not just mistaken. You need to be hauled off in a straitjacket to the Institute for the Treatment of Investment Insanity. But when it comes to investing, there's only one sure bet: that sure bets don't exist."

So who is right?

To me, if I owned stocks, I would probably own somewhere between 6 and 10 stocks. I think that individual investor simply cannot find time to watch any larger number of positions.

But I don't own stocks. I switched to options a long time ago. Here is why.

Let's say you owned a nice diversified portfolio at the end of 2007. How would it help you?

  • Apple (NASDAQ:AAPL) declined 60% from $200 to $80.
  • Cisco (NASDAQ:CSCO) declined 60% from $34 to $14.
  • Citigroup (NYSE:C) declined 98% from $55 to $1.
  • Google (NASDAQ:GOOG) declined 66% from $750 to $260.
  • General Electric (NYSE:GE) declined 85% from $42 to $6.
  • Ford (NYSE:F) declined 90% from $10 to $1.

Of course many of them recovered, but would you know to buy them at the bottom? And some of those stocks are still trading below 2007 levels.

But here is the biggest problem. As Bespoke Investment Group correctly point out, "One of the problems with diversification is that during times of turmoil, asset classes tend to become highly correlated, defeating the purpose of the diversification in the first place. This was especially true during the financial crisis in late 2008 when hedge funds and other asset managers were hit with massive redemptions. This caused even a safe haven like gold to fall along with everything else."

Diversification works well during bull markers, because securities tend to have low correlation - some of them will zig when others zag. But during bull markets you don't really need to be diversified - most stocks will go up anyway, or you can just buy a broadly diversified ETF lile SPDR S&P 500 Trust ETF (NYSEARCA:SPY). But when a bear market arrives, all stocks start to move in the same direction. Just when diversification is needed the most, most stocks become highly correlated.

So what is the truth behind diversification? Is it simply a Wall Street conspiracy to make you to trade more?

What do Seeking Alpha readers think?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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