What Does Diversity Mean?

The year 2000 has been a brutal one for those who hold many of the "hot" industries from the end of last decade. Bill Mann has in the past decried diversification as a remedy for those who do not know what they are doing, but in this article he explains that this appellation describes most of us. There are many routes to diversification, the best may be the good old index fund. But just because you hold 30 different stocks doesn't mean your portfolio is diverse.

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By Bill Mann (TMF Otter)
December 20, 2000

I'm going to back up and revisit a statement I have made several times in the past. It is, more or less, the fact that I believe that diversification is something for people who do not know what they are doing in investing.

The concept is correct, but I'm afraid that the message that I imparted was completely backwards. In fact, diversification is for people who do not know what they are doing. But in investing, this is the vast majority of people. So when I quote Warren Buffett, Chairman of FOOL 50 component Berkshire Hathaway (NYSE: BRK.A) as proof positive that diversification is not for everyone, don't misunderstand: that it is inappropriate for Warren Buffett in no way means that it is not utterly appropriate for you, or me, for that matter.

Over the past three years, even the rankest beginning investors have been able to make a killing in the market. This drew more and more people into the guile of equities, easy money, and the sure thing. Those who came late to the party got hit by a chainsaw called "the year 2000." Those who came earlier had at least some gains to fall back on, but for most, fall back they did. Even those who correctly foresaw the Internet as a bubble have seen other "safe" industries blasted as well. Telecommunications, for example, was the "arms dealer" industry in 1999. It was generally believed that data requirements were expanding so quickly that communications companies -- carriers, equipment manufacturers, and component producers -- were going to expand no matter what.

But then, to paraphrase George Clinton, reality stepped on these companies' collective funk. Bandwidth demand continues to rise, but the revenue per bit has dropped considerably, making the economic assumptions under which these companies were built obsolete. And the demise of voice communications revenues, which, even if they were marginless provided a huge supply of cash flow, came much faster than had been expected. In the end, only the local exchange carriers, companies protected by their regulation-mandated local access revenues -- BellSouth (NYSE: BLS), Verizon (NYSE: VZ), Qwest (NYSE: Q) and SBC Communications (NYSE: SBC) -- have come through the year thus far relatively unharmed -- though they've been hammered the past couple of days.

This is where my earlier statements about diversification were off base. Almost every investor who jumped onto the "tech bandwagon" has been crushed this year. Gorilla Game, Rule Breaker, Changewave, Gilder, doesn't matter. Tech is getting blitzed. It may not stay that way, but those who hold the majority of their equity assets in just this sector are asking for more trouble.

"Geez," you say, "I haven't had enough trouble already? The Rule Breaker (not a pure technology portfolio, granted) is down 47%. Many tech companies are down much, much more. I spread my money across Internet companies, across telecom companies, across optical companies, and across biotechnology companies, but it hasn't done any good. I even bought Internet Capital Group (Nasdaq: ICGE) so I could have experts figure out the best B2B companies, and it's down 96%!"

Make no doubt about it, it's a tough, tough market out there, and particularly among the investors who started in the last three years, many of the lessons learned during the long bull market aren't worth a damn now. This is because, frankly, many of those lessons were wrong. This may smack of Monday-morning quarterbacking, but I assure you that someone with a 20, 30, or 40-year time horizon will see markets of all different flavors. Those who fail to learn from their experience this year will be doomed to repeat it over and over again.

One of these lessons is that diversification can be your friend. Unless you are Warren Buffett... well, you're not Warren Buffett, okay? Diversification simply means that you allocate your investments among companies in different regions, industries, and even sizes. Money managers go so far as to say that you should put a certain amount in bonds, a certain amount in international stocks, a certain amount in large cap stocks, and so on. To my mind this is a huge amount of overkill. If maximum diversification is the goal, why not just buy the Barclay's iShares Dow Jones Total Market Index (Amex: IYY), composed of proportionate stakes of every listed company in America? At a minimum, one of the index funds, such as Vanguard's or the Spider (Amex: SPY) or Mid-Cap Spider (Amex: MDY) provides an investor an inexpensive way to own several hundred companies at a fraction of the cost of buying each one separately.

There are dozens of ways that diversification can be achieved, but know this: very few of us have the knowledge, discipline and skill to be able to have portfolios that are concentrated in only a few industries or a few stocks. Still, the person who owns three stocks -- Yahoo! (Nasdaq: YHOO), baking soda manufacturer Church & Dwight (NYSE: CHD), and White Mountains Insurance (NYSE: WTM) -- is much more diversified than the person who owns 30 optical networking companies, even if one of them is a monster like JDS Uniphase (Nasdaq: JDSU). Even after the huge drop suffered by Yahoo!, the performance of the other two companies has mitigated the loss. Moreover, the economic event that would materially harm Internet, insurance and -- whatever you want to classify baking soda as -- companies is rare indeed.

All too often we investors have relied upon a noxious cocktail of our own research and groupthink to come up with our portfolios. The highly successful investor is not the one who lists a bunch of ticker symbols on the "hot" industries. Rather, it is the person who is able to balance both the opportunities and the risks that are a necessary part of equity ownership. The goal of a superior investor is both asset appreciation AND capital preservation. What the last three years taught many was that the second part of this equation was not something worth worrying about.

Well guess what? It is worth worrying about. To succeed in investing requires that you have something to invest -- a drop to near zero midstream is not an acceptable outcome, and it generally means that you have taken outsized risks and lost. The goal of diversification, of buying great companies that lie in several different sectors of commerce, should assist in limiting the overall effect of a downturn in one or more sectors.

It may not feel like it to many of you, but several sectors have had excellent years in 2000. Utilities, insurance, petroleum, even consumer products have all had positive years. This is something that is nearly impossible to anticipate over the short-term. Better for those of us who lack the myriad tools needed to make the superior investing decisions to bet big on certain companies or sectors to build a portfolio that is spread out over a wide swath of commerce. Or buy an index fund and forget about it.

In the end, diversification may be for those who do not know what they are doing. But in most situations, "they" is us.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards