Diversification is an issue in investing that pops up from time to time and can cause a good deal of confusion for investors. For example, there has been much talk of late on why investors should diversify into so-called "cyclical" stocks right now. We're not talking about companies that sponsor teams for the Tour de France, but rather companies that operate in industries that tend to expand and contract with some degree of regularity along with the general feel of the economy.
If you have listened to financial TV shows recently, you've probably heard a Wise commentator talking about the recent strong performance of many cyclical stocks and saying something to this effect:
Wise commentator: "The cyclicals look really strong, Bill. Investors should rotate back into these forgotten, unfairly maligned companies. These companies have real tangible assets on their balance sheets and look cheap right now."
Wise interviewer: "What about the Internet stocks and the tech stocks? What's your view on them?"
Wise commentator: "I've been telling people for months that the Internet hype is just that -- hype. Look at America Online (NYSE: AOL) with its P/E ratio of 100 or 200. It's no surprise that it has fallen 12% the past month. Compare that to Alcan Aluminum (NYSE: AL), a company with real factories that actually churn out real products. It has a P/E of 26 and is up 13% over that same span. It's just a no-brainer, Bill."
Wise interviewer: "Good point. With thinking like that, it's no wonder that the mutual fund you manage returned 7% last year, outperforming all other general equity funds managed by white males over the age of 50 with mustaches and diabetes."
So, is this the time for Drip investors to think about diversifying their portfolios into forgotten-about industries? Should you feel guilty about owning too many "tech stocks" and not enough "cyclicals"? And why is every financial TV show host named Bill, Bob, or Lou?
Fools from around the globe often send us e-mails asking these types of questions. When I receive questions along these lines, I tend to do the most logical thing -- I hand them to Jeff. Here's what Jeff recently had to say about diversification:
"We will likely own six to eight stocks at most. There is such a thing as too much diversification, and I believe that once you get past, say, eight to ten stocks, you can begin to suffer from it. Besides, Drips are typically large, diversified companies as it is. Overall, for our Drip purposes, I believe in the philosophy of concentration. Buy and keep buying what you know and like best. Don't ruin your potential return by spreading your money too much (increasing transaction costs, mistakes, etc)."
I couldn't have said it better myself, which is why I let Jeff say it. The Drip Port's main mission in life is to build a portfolio worth $150,000 in 20 years by investing $100 each month in Drips. To do that, we need to identify and invest in the companies that offer the best potential of returning an average of 15% annually over the next few decades. Diversification isn't really part of the equation. We may meet our goal with the four Drips we have now or with eight Drips. Whatever the number, we will only invest in companies that we know and understand very well.
With only $100 to invest every month, our ability to diversify is immediately limited. Assuming we wish to invest equal amounts in each stock on an annual basis (which we don't necessarily do here, but that's another can of worms), holding six stocks in the portfolio implies investing in each one of those stocks twice every year. With 12 stocks, we would theoretically only invest in every stock once a year. As Jeff has mentioned before, that kind of framework undermines the power of dollar cost averaging, which is a major reason why we like Drip investing so much in the first place.
So, how many Drips should you hold in your portfolio in order to realize your long-term goals? We don't know. It depends on your individual financial situation, the goals that you have set for yourself, your ability to tolerate or ignore volatility, and the confidence you have in the growth prospects of the companies in which you invest. Maybe one Drip will do the trick, or maybe more will be needed to allow you to sleep well at night. The point here is that all investors are different and there is no magic diversification number.
When thinking about choosing stocks for this portfolio, I often recall this short anecdote from Warren Buffett that Buffett's longtime pal and business associate Charlie Munger relayed in a speech carried by Outstanding Investor Digest:
When Warren lectures at business schools, he says, "I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches -- representing all the investments that you got to make in a lifetime. And once you'd punched through the card, you couldn't make any more investments at all."
He says, "Under those rules, you'd really think carefully about what you did and you'd be forced to load up on what you'd really thought about. So you'd do so much better."
To Jeff and me, that kind of thinking makes crystal-clear sense.
To read more about the thinking of Messrs. Buffett and Munger and to come to understand their company, Berkshire Hathaway (NYSE: BRK.A), check out Motley Fool Research's brand new report on the company. The report clearly explains all of the businesses of Berkshire Hathaway, how the stock has been one of the best performing of any in the past 25 years, and why it may now be undervalued.
Have a great Fourth of July!