In Part 1 of this article, I discussed the benefits of a 10-stock, 10% portfolio allocation as one very effective way to naturally hedge your portfolio. This allocation ensured that no single stock could hurt your portfolio by more than 10%. One or two good investments can readily make up for a single bad one, if your losses are reasonable.
However, on its own, this allocation doesn't provide much of a hedge. You need to do one other thing.
Pay attention to what you buy
Imagine it's the year 2000, and you have a portfolio of 10 stocks each comprising 10% of your portfolio. Enjoying the past profits the Internet craze provided you, your portfolio's holdings include Cisco
If this was the case (and I'm sure it was a very common occurrence back then), you didn't own five different stocks -- you owned one big Internet stock worth 50% of your portfolio. In financial terms, all of these stocks were positively correlated with one another. If one rose or sank, the rest would likely follow.
Unless you're a savvy trader with extremely lucky market-timing abilities, any big profits you made during the net boom were likely erased during the net crash. Remember all those hot internet funds that were returning triple digits in 1999 and 2000? By 2003, most, if not all, had given back all those gains, and then some. The market giveth, and the market taketh away.
To each (stock) its own
On its own, merely allocating a set percentage of assets to a single stock is useless if all the stocks are subject to the same set of risks. Instead, attempt to invest in securities subject to different business conditions. For example, an oil company, e-commerce business, and a bank operate in highly different industries. A rapid decline the in the price of oil theoretically should not deteriorate the fundamentals of a financial institution, and so on.
Instead of investing a couple of percent each in various businesses in the same industry, why not concentrate your assets in the single best business within that industry? Instead of 3% in three different oil companies, why not 10% in one, or even 5% or 6% in two businesses (domestic and international, if you like)?
Of course, I would never advocate merely putting money in eight to 10 different investments across different industries without first understanding the businesses cold. Investors must always operate within their circle of competence and stick to what they know. My idea of hedging your portfolio in this fashion comes second to the most important concepts -- investing in what you understand, and making those investments at attractive prices. If you don't follow these two tenets, no amount of allocation, correlation, diversification, or any other fancy words will help your investment returns.
The quality of the investment should always come first. It protects you from any miscalculations in your analysis.
Remember your limitations
For me, this approach seems to work within my circle. Investing is a dynamic process that sometimes requires a few tweaks along the way. Yet some investing attributes will always remain intact. Don't try to jump seven-foot hurdles when you can easily walk over one-foot obstacles. Stick to an investing process that is supported by your data and reasoning, and you'll be fine.
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Fool contributor Sham Gad is managing partner of the Gad Partners Fund, a value-centric private investment partnership modeled after the 1950's Buffett Partnerships. He has no positions in the companies mentioned. The Fool has a steady disclosure policy.