New Year’s Investment Resolutions – #3

Wednesday, December 30, 2009

Number 3Continuing with my favorite resolutions this week – ones that work in all markets – here is number three.

Diversification: A timeless key to investment success, the practice cycles in and out of favor, depending on the market environment. Here is how to view and manage diversification for good results in all markets.

First off, there is the question of whether diversification is necessary. Some top investment professionals say it is overrated. For example, Warren Buffet says, “Wide diversification is only required when investors do not understand what they are doing.” This is one time to ignore his normally sage advice. Top professionals, like Buffett, are people who have a special flair for investing, the time and resources to investigate and understand companies and securities better than most, and have access to top analysts and other experts. They also can buy very large positions that give them some management control over the companies. (Note that, in spite of what he says, Buffet actually practices diversification, holding many companies in different industries.)

The media periodically has articles that imply diversification produces mediocre performance. For example, write-ups about Apple Computer going from $7.50 to $200.00. Such stories have us mentally calculating what our assets would be if we had just bought the one stock. To counter this excitement, glance through a chart book and look at all the individual stocks that would have depleted your assets. And don’t forget the ones that have gone out of business.

Diversification is not only good investing, it is a key to success. An investment’s results cannot be known in advance, so it is better to take smaller positions in a number of promising investments than to bet the farm on one or two. Doing so also allows us to take on a riskier position that has a large potential – if it doesn’t work out, it won’t severely damage our portfolio.

Diversification has an additional, very large benefit: it provides peace of mind. Knowing that no one or two positions can undermine our strategy, we can objectively observe and make decisions without being driven by emotional turmoil.

This leads to our third resolution:

#3 – I resolve to always practice sound diversification.

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