Risk Management
...through diversification

by George Runkle(TMFRunkle)

ATLANTA, GA (June 7, 1999) -- This week I want to write about diversification. We can research our investments forever, use all sorts of sophisticated stock pricing models, and still find ourselves buying stocks that just don't make it. If research and analysis provided 100% reliability, you wouldn't have so many mutual funds underperforming the market. Unforeseen events can take their toll on companies. They might involve poor management decisions, poor acceptance of new products, natural disasters, or an economic crisis.

So, how do you protect yourself from loss? There are a few different ways, but clearly only one of them will make sense to Fools. You could sell as your stock price drops, you could use options, or you can diversify your holdings. I'm sure you know where I'm going with this; I personally believe in diversification. Let me talk about the first two methods first and share why I don't believe they are a good risk hedge.

First, let's look at selling stock if the price goes down. At what time do you sell? Is it when the price drops 10%?... 20%? That is the first problem. Some stocks naturally have wild swings in price, especially when day-traders are jumping in and out of them. You could sell your stock during one of these swings and find yourself missing out on big gains later. Besides, is it always a good strategy to sell when a stock price drops? If nothing fundamental in the company has changed, it probably isn't. You may be seeing the stock drop from short-term worries. Unfortunately, it's often hard to see if a stock-price drop is related to real problems, actions of traders, or overblown short-term worries until the price hits unbelievable lows. If you try to sell before that point, you may have just sold your stock at a temporary low.

Now, another way to hedge risks is by the use of options. This doesn't work for us Drip investors too well, since options aren't sold as part of a Drip account. But more so, options aren't the most Foolish way to invest in stocks -- in fact, they're probably more like gambling than investing. I personally don't like this method because you can be whipsawed out of your holdings when you don't need to be. Commissions also cut down your gains. For me, options are a bit more complicated than I like, and I suspect there may be some price manipulation on the expiration dates. Finally, statistics say that about two-thirds of options expire worthless.

This leaves my favorite method of risk reduction: diversification. Now, by diversification I don't mean you buy stock in Intel (Nasdaq: INTC) and AMD (NYSE: AMD). That's betting on all the horses in the race, and guaranteeing less or even no return. No, I mean diversification into holdings of companies in varied industries. For example, I have Drip accounts in Procter and Gamble (NYSE: PG), Coca-Cola (NYSE: KO), Johnson and Johnson (NYSE: JNJ), and (arrgh!) Compaq (NYSE: CPQ). If you wish, check out Compaq's chart and see what it has done since February. It has had continuing problems and fired its CEO. If this was my only holding, I would be hurting now. Fortunately, owning other companies has cut my overall losses to nothing. In fact, I am still gaining.

How many stocks do we need for diversification? According to my financial management text, you have almost completely eliminated "diversifiable risk" once there are 40 stocks in your portfolio. But that would be ridiculous. Not only could you not manage that number of stocks (who'd want to?!), but this kind of over-diversification would likely just dilute your returns. You'd probably be better off investing in an index fund if you wanted to diversify this much.

The bottom line is having that many stocks in Drips is hard to do for most of us, and probably not needed. Once you get to five stocks, your diversifiable risk drops significantly. Even to get to this point may be difficult for many of us, since putting away the minimum monthly investment in five Drips may be more than our finances can handle. I personally "leapfrog" my investments. Right now I'm not putting anything monthly into Procter and Gamble, Coke, or Compaq. I'm putting my monthly investments in Johnson and Johnson. Once it reaches a point I am satisfied with, I will leapfrog to one of the other stocks. This allows me to build a diversified portfolio and cut my risk with a small amount of money each month.

Summing it all up, there are risks in the market that cannot be foreseen. Of the different strategies for lowering these risks, I feel diversification is the best. Speaking of risks, in the future I will cover the problems Compaq has had, and if any of us could have foreseen them.

Would you work for a bunch of Fools?

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