Fool.com: Diversification Isn't All That [Rule Breaker] April 24, 2000

Rule Breaker Portfolio
Diversification Isn't All That

By Bill Mann (TMF Otter)
April 24, 2000

Well, once again the Nasdaq stock market has been pummeled, today to the tune of some 5%. To celebrate let's expose all our best clich�s about the Nasdaq -- the "tech-heavy," the "technology laden," the "New Economy" Nasdaq. The "dot-com bubble."

Oh, and here's my newest intelligent-sounding, but materially vapid term. Have you noticed how wags like to frame their points by saying "in this market"? I had an English teacher in high school who called such terms "Musbergers," after sportscaster Brent of ABC fame. He loves using terms such as "lifestyle" and "level," things that add exactly nothing to the point he is trying to make. When I hear someone talk about such and such "in this market," I've begun to automatically question the validity of whatever point they were trying to make.

Beyond the Nasdaq, the driver for our current market drop, the Dow Jones Industrial Average, the S&P 500, and the Motley Fool NOW 50 have all held up quite well over the last few weeks, with the Dow and the S&P being up by 10% and 5%, respectively over the last month, and the NOW 50 up by about 1%. For our own NOW 50 I'm especially gratified by its withstanding of the collapse of many of the "hot stocks du jour," as it has among its component companies that should, if the doomsayers are to be believed, be falling into the slagheap of financial irrelevance. And yet, an index that includes such newly minted issues and such aggressively valued companies as Amazon.com (Nasdaq: AMZN), Biogen (Nasdaq: BGEN), ARM Holdings (Nasdaq: ARMHY) and AOL (NYSE: AOL) is providing a very balanced view of the performance of the global economy.

Also, before you let the financial newsmakers drag you into despair about the "collapse" of the stock market, recall that the S&P 500 is comprised of 500 of the largest and most relevant American companies with a total market capitalization of $12.6 trillion dollars, larger than the Gross Domestic Product of the United States. And, ahem, it's up over the last month, and only slightly down for the year.

Anyhooo, I thought I'd spend this article taking about another term that investors, pundits, the Wise, and others seem to bat about with exactly zero introspection about what they are saying. It's diversification. Diversification seems to be the one point upon which investors and investment writers from all cuts of the cloth agree on. It's good. It's necessary. And everything from the portfolio losses to toilet bowl rings have been blamed upon a lack of investment diversity.

There are a few heathens out there, calling it "diworsification" and such things, but they're decidedly in the minority, especially in times such as this when many portions of the market are dropping like a stone. Did you get caught up in the collapse of the Nasdaq? Probably because you weren't diversified enough.

(Chortle.)

The Rule Breaker portfolio is poorly diversified. It has also absolutely rocked in performance since its inception. In this period of time, we have witnessed two drops in the overall value of public equities by 20% plus, and several more 10% plus drops. And each time the stock market has dropped, the Rule Breaker portfolio managers have rushed out and done exactly zero "rebalancing," or other diversification-type actions.

And so we are stuck with a portfolio that is concentrated in Internet companies (four), biotechnology (two), and a beverage company (one). Worse, not only is the portfolio numerically composed of 57% Internet companies, we are nearly 67% concentrated in them from a portfolio value perspective.

And yet, the portfolio has returned 57% per year since its inception six years ago, a period of time that can no longer be described as brief. The Rule Breaker has never been diversified, and yet it has rocked.

Let me change this thinking just a bit. The Rule Breaker strives for a completely non-diverse portfolio. We want exactly 100% of the companies to be excellent, to be the best representatives of the most promising industries. We have no time for non-excellent companies, in the name of diversity or anything else.

So what am I saying? Am I anti-diversification? Well, no, not specifically. I am anti-dilution, and that is what many people tend to do in the name of diversification of assets. I am also perfectly comfortable with people who know a great deal about a specific industry to concentrate their investments within the best companies of that sector. The key factor is the level of knowledge, not the level of concentration.

I'll give you my own experience. I know telecommunications, since I come from that professional background. I know how the business works, and although I am not an engineer I do have some facility in understanding how components work and how the companies providing them derive profits. As a result, my portfolio is very heavy in telecommunications, from big, bad, bruising Nokia (Nasdaq: NOK), to Internet backbone provider PSINet (Nasdaq: PSIX) to international up-and-comer Primus Telecommunications (Nasdaq: PRTL). I believe these are the best in their fields, and I am convinced that I know why.

But telecom has dropped as of late, as have my holdings listed above. Severely. Does that mean that I should run and put some of my long-term gains in such profitless industries as airlines or steel for the sake of diversification? No. I want 100% of my money to be in companies that don't suck, in industries that are growing. Fortunately, off the bat that eliminates 90% of all of the available stocks.

Diversification is a good thing, in and of itself. The theory is that companies in various industries are beholden by different economics, so when the PC industry has a downturn, the banking industry is not effected. But lately diversification has seemed to take on two less tenable meanings. Either people hold way more companies than they could effectively cover -- something more akin to collecting companies rather than investing in them. Or there has been an ascendant belief that diversification is specifically related to how much of one's portfolio is invested in "tech stocks."

Thirty percent tech, 40% tech, 100% tech. Grrrrr. Here's the thing, and I mean this in the best spirit. If someone is giving you advice based on how much of your portfolio is "in tech," then they are actually telling you one of two things. Either they don't think you are very smart, or they themselves know less than they think about commerce. Because in either case they are taking a group of 1000 or so companies, or even worse, "the Nasdaq," and treating them as if they are a single unified force. Investing heavily in AOL or Cisco (CSCO) is very different from investing in some of the more shaky pretenders to the "tech" mantle. I'd rather be 100% invested in Yahoo! (Nasdaq: YHOO) than to have my investments spread across a diverse group of less-than-stellar companies.

"Technology" is not going away. But a fair number of the technology companies are in fact going to wither up and fail. It's just life in the jungle, and nothing positive or negative that I or anyone else says about them will change their fate. The key to investors is staying away from these companies, in the name of speculation, diversification, concentration, or anything else.

Stick with the best and stick with what you know, even if it means buying fewer companies in the long run.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards






Rule Breaker Portfolio

4/24/2000 Closing Numbers
Ticker Company Day Chg % Chg Price
AMGNAMGEN INC-2 11/16-4.98%$51.31
AMZNAMAZON.COM-2 9/16-4.89%$49.81
AOLAMERICA ONLINE-2 1/4-3.77%$57.50
ATHMAT HOME CORP CL A-1 3/8-7.67%$16.56
CRAPE CORP - CELERA GENOMICS GRP-4 15/16-6.59%$70.00
EBAYEBAY INC-8 3/8-5.57%$141.88
SBUXSTARBUCKS CORP1/26.68%$39.94

  Day Week Month Year
To Date
Since
8/5/1994
Annualized
Rule Breaker -4.22% -4.22% -19.46% -22.47% 1,160.18% 55.71%
S&P 500 -.33% -.33% -4.59% -2.68% 211.92% 21.99%
S&P 500(DA) -.33% -.33% -4.59% -2.68% 226.18% 22.95%
NASDAQ -4.43% -4.43% -23.84% -14.42% 383.56% 31.71%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg
8/5/19944020AOL0.460$57.5012,410.51%
9/9/19972640AMZN3.188$49.811,462.74%
12/16/19981160AMGN21.444$51.31139.28%
12/17/19991260CRA39.756$70.0076.07%
7/2/1998470SBUX27.955$39.9442.87%
2/26/1999300EBAY100.527$141.8841.13%
12/4/1998900ATHM28.040$16.56-40.93%

Trade Date # Shares Ticker Cost Value LT $ Val Ch
8/5/19944020AOL$1,847.65$231,150.00$229,302.40
9/9/19972640AMZN$8,415.03$131,505.00$123,090.00
12/17/19991260CRA$50,093.00$88,200.00$38,107.00
12/16/19981160AMGN$24,875.50$59,522.50$34,647.00
2/26/1999300EBAY$30,158.00$42,562.50$12,404.50
7/2/1998470SBUX$13,138.63$18,770.63$5,632.00
12/4/1998900ATHM$25,236.13$14,906.25($10,329.88)
  Cash: $43,249.36  
  Total: $629,866.30  



Note
The Fool Portfolio was launched on August 5, 1994, with $50,000. It was renamed the Rule Breaker Portfolio in October 1998. The investing strategy began with the first investments of the Fool Port and has evolved with time and experience. In July 2001, the portfolio began adding $12,500 each quarter (We missed Jan. 2002, so we added $25,000 in April 2002). We skip a quarter if we have enough uninvested cash or cash available in stocks we would prefer to sell to make new investments. All transactions are shared and explained publicly before being made, and returns are compared in each week's column to the S&P 500 (including dividends where noted) and the Nasdaq composite. For a history of all transactions, please click here.