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Wednesday, November 7, 2018

Why Diversification Matters!

By James Pattersenn Jr

Regardless of whether you consider yourself a value investor, dividend investor (income), growth investor, or dividend growth investor, diversification should be an integral part of your investment program because it does matter.

Here’s why.

I don’t know of any investors that invest with the intention to lose money on purpose, yet, a portfolio that lacks diversification sets up an investor for some serious losses when the stock market takes a turn for the worse or when specific economic troubles influence the stock market or even a specific industry.

Before going any further, let’s look at a definition of diversification and what it means for investing in the stock market.

Investopedia defines diversification as a risk management technique that mixes a wide variety of investments within a portfolio.

This simple definition can be interpreted in various ways, such as diversification among different asset classes or diversification within a single category of a specific asset class.

For example, a portfolio that’s diversified among different asset classes may contain stocks, bonds, real estate, and commodities, whereas a portfolio that is only diversified within a single category of a specific asset class may contain only stocks and/or stock funds.

For simplicity, I’m not going to discuss the variations of diversification but mainly want to stress that diversification does matter when it comes to investment performance.

We will look at a real-life example of what happened to the performance of the portfolio of a very reputable hedge fund manager named William “Bill” Ackman, whose Pershing Square portfolio lacked diversification. Yes, the world’s best investors make mistakes too, and we can learn from those mistakes. I will also tell you about one of my major screw-ups.

First, let’s look at Ackman and Pershing Square.

According to an analysis performed by Fortune, Ackman lost more than $4 billion on his investment in Valeant Pharmaceuticals, a position that he had held in the Pershing Square portfolio for about two years before finally closing the position in March of 2017. According to Fortune, the loss was equivalent to losing $7.7 million every day that the market was open for more than two years!

From my observations, Ackman tends to run a stock portfolio that is very concentrated with fewer than ten stocks in it and places very heavy bets on a few of those stocks that he has the greatest confidence in. At one point, the Valeant Pharmaceuticals shares accounted for nearly 25 percent of Pershing Square’s portfolio.

In running such a concentrated portfolio and betting big on just a few stocks, I believe that Ackman’s portfolio lacked the diversification that was needed to protect him from devastating loses such as Valeant Pharmaceuticals. Although Ackman is a master stock picker, anything can happen to any company.

A better option for Ackman would have been to diversify into more holdings across a variety of industries and sectors using the methodology that has worked so well for him in the past. In addition, his performance would have been better had he not put 25 percent of the assets under management into one stock or company. In the end, it cost Pershing Square more than $4 billion dollars and resulted in some damage to Ackman’s reputation as a great investor.

The numbers tell it all. At the end of 2014, Pershing Square’s portfolio had more than $16 billion in assets under management. Today that value stands at slightly less than $6 billion. Although Ackman manages billions and you may not, and I certainly don’t, diversification matters. What happened to him can happen to you and me if we fail to diversify our portfolios.

I will not end this article without telling you about just one of the mistakes I have made when it comes to diversification or the lack thereof. Although there was only a small amount of money involved, the mistake was much worse than Ackman's!

In 2007, I was researching stocks and discovered one that perfectly met the criteria I was using to pick stocks at the time. With all my money already tied up in other stocks, I went to my local credit union and borrowed $5,000 to invest in that one stock that seemed so perfect.

After receiving the money, I immediately opened a brokerage account and put the entire $5,000 into that one stock or as some would say, “I put all my eggs in one basket.”

I forgot how long the term of the loan was but I’m sure that it was for at least 24 months. Not soon after my purchase, the recession hit and I watched my $5,000 investment drop to almost zero. There was no coming back! To make matters worse, I still had to continue to pay back the loan even though the investment was almost worthless. It was like pouring hot coals on my head.

The investment that I had made was in First Marblehead Corporation (FMD) and it was a big mistake not to diversify the $5,000 into several investments! I would have been much better off had I put those funds into ten stocks from a variety of industries and sectors. Had I done so, I probably would have made money instead of losing it.

It has been stated again and again that “Diversification is the only free lunch in investing.” If you take nothing else from this article, please remember that diversification matters and it matters big time!

This article was written by James Pattersenn Jr of howtoinvestinstocks.org
James is a private investor and the author of the book titled
You Can Invest Like A Stock Market Pro.

James is a fitness enthusiast and loves to weight train and to power walk when time allows.

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