When Crystal Balls Break

I'll be the first to admit that my crystal ball is broken.

The lousy thing cannot help me predict the future at all. It did not tell me, for example, that Merck (NYSE:MRK) would find sufficient trouble with Vioxx to justify an instant, worldwide, and early complete withdrawal of the drug. In late November 2003, the company faced questions about its pipeline. I took the opportunity to buy a small position in Merck, believing that my price of $41.23 represented a decent price for the firm. The company was below any price it had been since 2002. While I knew I wasn't getting the type of bargain Fool value guru Philip Durell targets for his Inside Value newsletter, I thought that I was finding a solid company at a fair price.

That was before the Vioxx incident. Like many other investors, my account got hit when Merck announced its withdrawal. Fortunately, through the power of diversification, a single-company problem like Merck's had a muted effect on my portfolio, and all in all, I'm holding my own.

Diversification, when done right, is the only free lunch (or nearly free lunch, at least) in investing. There are no guarantees, of course -- even well-diversified portfolios can lose money. And although in theory it's possible to make more money by investing in fewer stocks (diversification spreads out your gains as well as your losses), virtually all investors -- especially value investors -- are willing to give up the occasional wild upside for protection against the inevitable one- or two-stock plunges that wreck undiversified portfolios.

Two simple rules
There are two key rules of proper diversification as it applies to the value investor, and those rules must be followed to keep diversification from turning into di-worse-ification. The first key rule is that the companies must be in separate and unrelated business lines. Computer chip makers Advanced Micro Devices (NYSE:AMD) and Intel (NASDAQ:INTC), for example, are in substantially similar businesses, so owning both would not help an investor's diversification. Owning one of those computer chip companies along with Pepsi (NYSE:PEP), whose Frito Lay division makes potato chips, on the other hand, would be sufficient business separation.

The second key rule is that an investor must keep each company's value in mind when making each individual purchase. In other words, don't use diversification as an excuse to stop hunting for values. Google (NASDAQ:GOOG) may be in a totally separate business from United States Steel (NYSE:X), but that doesn't mean that either one of them would make a particularly good investment at any price. In the recent article "A Valuation Classic," I used a 12% discount factor to determine valuation. That 12% represents my required rate of return -- the total return over time that I would expect to receive if a company I own managed to meet my operating and growth expectations. Using that number, which is moderately high as discount rates go, to help determine my purchase price keeps me focused on not overpaying for any given company. Were I to ignore valuation, my expected return would suffer.

The rubber hits the road
With those thoughts in mind, it is relatively straightforward to set up a pretty well-diversified portfolio and have a measure of protection against individual company problems. For an example, take a fictional investor who had an equal dollar stake on Dec. 31, 2003, in these 10 companies: insurance company Allstate (NYSE:ALL); pipeline company Kinder Morgan (NYSE:KMI); clothing retailer Gap (NYSE:GPS); software giant Microsoft (NASDAQ:MSFT); mortgage finance giant Freddie Mac (NYSE:FRE); mall operator General Growth Properties (NYSE:GGP); restaurateur McDonald's (NYSE:MCD); the aforementioned Merck, home improvement warehouse Home Depot (NYSE:HD); and waste collection company Republic Services (NYSE:RSG).

The following chart illustrates the year-to-date performance of such an investor's portfolio, as of market close on Oct. 18:

In spite of Gap's meandering, Microsoft's stagnation, and, yes, even Merck's Vioxx problems, this account would have held up quite well. Compared with the S&P 500, as represented by "Spiders," which are shares of an ETF that tracks it, this portfolio absolutely shined. During the comparable period, the Spiders moved from $111.28 to $111.68 and paid $1.28 in dividends, for a year-to-date total pre-tax return of about 1.51%. Just prior to Merck's Vioxx-induced stock collapse, it closed on Sept. 29 at $45.07. Had Merck's price remained constant in the absence of the Vioxx recall, this portfolio would have shown a year-to-date total pre-tax return of about 9.79%. While Merck's impact still hurt, its blow was reduced by the risk-reducing power of diversification.

"Wait a minute!" you say, or at least think. Isn't the S&P 500 the epitome of diversification? Why not just buy it, or at least hold a whole bunch of stocks, to maximize the diversification benefit? Good thinking, as it brings up an important question: At what point is diversification too much of a good thing, in the sense that it ends up diluting an investor's hard-won returns?

Well, technically you're diluting from the moment you add a second stock, but academia has indicated that the bulk of diversification's benefit comes in the first eight to 10 stocks. Tying this into Rule #2 -- don't forget to hunt for value -- doubles the support for holding a moderate number of stocks; it's hard for a thorough, value-investing type to find and keep abreast of too many bargains in the first place. Bottom line? There's no single magic number, but a value investor would do well to stay within the bounds of his or her research capabilities.

Parting words of wisdom
Don't just take my word for it. Legendary value investor Benjamin Graham had this to say, via his now-classic volume, The Intelligent Investor, on the subject: "There is a close logical connection between the concept of a safety margin and the principle of diversification.... Even with a margin in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss -- not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses...."

To paraphrase the master, the individual companies matter, but in the end, it's the total portfolio that has to pay the bills. Value investors, such as the folks over at Inside Value, look for ways to improve their risk-adjusted returns. Proper diversification is one method by which investors can reduce the risk to their portfolio as a whole without significantly compromising their overall expected returns, making it a key tool for any value investor's kit.

Fool contributor Chuck Saletta owns shares of Merck and Kinder Morgan Management, a related company to Kinder Morgan. The Motley Fool is investors writing for investors.