One Way to Naturally Hedge Your Portfolio

Editor's note: An earlier version of this article incorrectly stated that First Marblehead is a mortgage player. We regret the error.

A lot of investors right now wish they had hedged their portfolios over the last year or so. How nice would it have been to have shorted Pulte Homes (Nasdaq: PHM  ) , Hovnanian (NYSE: HOV  ) , or any homebuilder, for that matter?

How smart would you now "appear" if you were the one buying all those put options on mortgage players like Countrywide (NYSE: CFC  ) ?

I don't do options and short sales, and I don't think I'm smart enough to participate on the winning side of these bets. So I avoid them. However, as an ardent follower of Graham and Buffett, I do pay very close attention to the risk of my portfolio.

Forget diversification
Much to my professors' chagrin, I also don't believe diversification is as effective as they make it out to be. Sure, diversification will help preserve your capital, but it can also prevent you from compounding your capital. A point that's debatable, but one I think most of my old professors will agree with, is that with a portfolio of 8-10 stocks, diversification has a meaningless, if not negative, effect on your investment performance. Instead, by doing only two things, you can have a wonderfully hedged portfolio. Here's the first.

Part 1: The 10% rule
Through my readings and observations of investment manager Mohnish Pabrai, I have come to appreciate the brilliance behind allocating no more than 10% to any single investment. Consider a portfolio of 10 stocks, each comprising 10% of your assets. Imagine after one year, the return on each security looks something like this:

Stock 1: 10%
Stock 2: 10%
Stock 3: 10%
Stock 4: (50%)
Stock 5: (80%)
Stock 6: 10%
Stock 7: 200%
Stock 8: 30%
Stock 9: 50%
Stock 10: 20%

A portfolio consisting of 10 securities with the above individual performance would produce an annual rate of return of 21%, an absolutely phenomenal rate of return that would most likely top a large majority of investment "pros."

Given the tumultuous conditions in the credit markets over the past year or so, the above estimates are not that unrealistic. If you purchased any homebuilder or finance-related company in the past year, there's a good chance that they're lucky stock No. 4 and 5 above. If so, my best advice is to get over it. All investors make mistakes and will continue to do so. Even smart guys like Buffett make them.

The key takeaways from the above portfolio are very important and must be fully understood:

1. Not too many mistakes
Buffett told me once, "It's OK to make mistakes. But too many mistakes will kill you. You don't want to make too many mistakes." Notice in the above portfolio, the investor made two major mistakes. That's a phenomenal win/loss ratio. In fact, if stock No. 9 had delivered only a 10% return vs. 50%, the portfolio would still be up 17%. If you can consistently deliver more winners than losers, even at 60/40, chances are you will deliver solid results. In The Science of Hitting, Ted Williams devised a matrix in which he would swing only at those pitches that landed in his hit zone. Williams is currently the last person to bat over .400 during a season.

What this means, of course, is that you should always be performing excellent due diligence on your investments. None of this can help you if you're constantly investing in losers or swinging at every pitch. Wait for Mr. Market to throw you a fat one -- there are no called strikes.

2. Don't overcommit. Stay disciplined
The other key takeaway is that by committing only 10% to each security, the most you will ever lose on single investment is 10%. This is a very important concept. A 10% loss can be easily overcome with a couple of good investments. One great multibagger investment, and that 10% loss just vanishes. Well, relatively speaking, that is. Equally important, by allocating 10%, you're inherently putting your money in your 10 best ideas. As it stands, if you aren't comfortable investing 10%, then you shouldn't be investing 1%. Concentrating your portfolio in your 10 best investments forces you to remain focused.

The other side of the coin is not getting greedy and wanting to put more than 10%. Let's face it. Most investors don't have the discipline or ability of a Warren Buffett, who put nearly 30% of his partnership's assets in American Express (NYSE: AXP  ) amid the salad-oil scandal. It becomes exponentially more difficult to dig yourself out of a 30% vs. a 10% loss.

The important thing is to sleep well at night
This is simply one Fool's opinion on a rather simple, yet highly effective way of being able to harvest your gains to cover your inevitable losses. Plenty of other smart investors do their thing and do it well. However, you can't argue with the logic the above numbers demonstrate. Of course, putting 10% in any old stocks is the first part. We'll complete the process in the next article.

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