No. of Recommendations: 23
TMF frustrates me. I mean it. I am really frustrated. It frustrates me when TMF takes a cavalier attitude towards complex issues. I get frustrated when TMF dismisses decades of research from the most brilliant minds in the field because they (TMF) believe they own the market on “logical” thinking. Excuse me Mr. Einstein, I'm no physicist but I am an English major, so let me show you why your little relativity theory makes no sense.

The most recent Fool on the Hill articles on diversification aren't just wrong they are incredibly wrong. Frustratingly wrong. So wrong that I am finding it hard to put together an unemotional response (due to the frustration don't you know). Luckily, norationalbasis provided a link to an excellent post from albaby that explains the intricacies of diversification much better than I could.

So that leaves me free to put aside my frustration and simply comment on the mis-statements of fact from the articles.

#1: The point of diversification is to minimize risk.

While that can be a benefit of diversification, the point of it all is to earn greater returns for the same amount of risk. The crucial insight of MPT is that the risk of an individual asset does not matter, rather it is its contribution to the portfolio's risk as a whole that we care about. And that is where TMF does not get it. Stocks have risk. Even if you don't believe in EMT and think you can beat the market with "in-depth" research, stocks still have risk. While the market rewards some of that risk with return, the remaining risk . . . well, not so much. If you don't diversify, you hold risk that isn't being rewarded. Let me repeat that, because the Nobel committee thought it note-worthy. If you don't diversify, you hold risk that isn't being rewarded. The point of diversification isn't to remove risk, it is to remove the risk that isn't rewarded.

#2: The way to minimize risk is by researching a stock.

First of all, the only way to minimize risk, is to be fully diversified . . . and I mean fully. If you are going to own stocks, you will always have more risk than the market unless you own the market. Period. Mathematical fact. End of story.

Secondly, it is highly questionable whether researching a stock reduces your risk at all. There is no shortage of empirical studies that address this issue and the bulk of them say research won't help you. But that is really irrelevant. I didn't bring this point up to debate EMT, but rather to get a handle on the amount of risk-reduction if we assume that research does help. In other words, if the issue of whether research helps is still unproven, then assuming it does, the amount that it helps must be awfully small, else it wouldn't be debatable.

So from an empirical perspective we have diversification which is easily quantifiable and known to have a large risk-reducing effect. On the other hand, we have stock research, which is not so easily quantifiable and has a small risk-reducing effect (if any). Logically, which method do you think truly minimizes risk.

#3: An un-researched stock is riskier than the market.

By definition, the expected value of a blind draw from a population, is the population mean. Investing is no different. If you buy a stock without researching it, your expected return is that of an equally weighted average of the market. To suggest otherwise defies the laws of probability.

Yes, you could get unlucky and own Enron or WCOM, but you could also have gotten lucky and owned a 10-bagger. The point is there is no empirical reason to think that buying a stock without researching it should have a lower expected return than the market. (Besides many, many people who do research for a living researched WCOM and Enron and owned them anyway.)

#4: You can be "Over-diversified".

Since stock returns are not perfectly correlated, every time you add a stock to your portfolio, you reduce the portfolio variance. The effect is inversely proportional to the number of stocks you hold so that adding a second stock provides a greater benefit than adding a third, which provides a greater benefit than adding a 4th etc. etc.

However, that benefit, while incrementally growing smaller, never becomes negative. In other words, you don't get to a point where adding stocks harms you, which means from a volatility perspective, you can't be over-diversified. Read another way, there is no such thing as over-diversification. Now all of this ignores transaction fees. So if you are adding stocks one by one at some point the risk-reduction benefit may outweigh the cost of adding that stock. Of course that can be avoided by index investing.

#5: Proper diversification can be accomplished with 6 to 15 stocks.

This is simply a matter of math. When Markowitz proposed Modern Portfolio Theory (you know that Nobel prize winning thingy that said diversification is good and has been the cornerstone of finance for 50 years), at least 30 stocks were necessary to sufficiently remove company-specific risk (some argued more).

However, since then due to changing market volatility and stock covariance the number required today for the same amount of diversification has actually increased. What 30 stocks got you in 1950, not even 100 will get you today. I will quote William Bernstein who is much smarter than I (and possibly anyone that writes TMF articles), "To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you."

TMF constantly tells us to do our homework. I wish they would do theirs.
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