An Argument against Diversification: Research Costs

Warren Buffet is someone whom I study because he says what I know to be true, but with clarity that I lack.

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." Warren Buffet [1]

My investment style is heavy on research. I start with a large list of companies whose products I've used or heard about. I hang out with people who are interested in stocks and I hear their stock choices. I then expand the list to include their competition. Then I go through and start research each one until I find the reason not to invest in them. In the end I find a few companies that are quality companies. In any given year, I find only 2 or 3 companies that I would bet my life on, and perhaps I should narrow even that down.

Even if I worked full time on stocks, I don't believe I could find 10 quality companies at fair or discount prices. Anyone who buys a handful of companies in year either has too much time or has done too little research.

Next week, I'll switch to a different series.

[1] Quotes by Warren Buffet, Wikiquote

An Argument against Diversification: Pareto Principle

Pareto principle applied to finances: 80% of your income comes from 20% of the sources. Let's say your income comes from a job, stock portfolio, house, savings account, and blog ads. The Pareto principle would assume that 80% of your income comes from your job. So why is it that most people focus on diversifying their stock portfolio, which counts for perhaps 15% of your income?

While the stock crash at the turn of the century emphasized the impact of losing one's portfolio. This occurred at the same time as many people were losing their jobs. While the stock market crash did sell more newspapers, people would do better to become less dependent on their jobs.

If your portfolio does provide the majority of your income, then I can see the argument for diversification. However, I still have one more argument to make on Thursday.

An Argument against Diversification: Commissions

For each trade you must pay the piper, or the broker in this case. If you're a billionaire making trades that are worth 500,000 dollars or more, then commissions aren't going to affect you. This is due to economies of scale. If you're reading this blog then you're probably trying to squirrel away a few nuts each paycheck. In this case commissions are going to impact you.

Lets say you have 100 dollars to invest and commissions are 10 dollars per trade. If you invest it all into one stock, then it counts as one trade. In this scenario the commission costs you 9% of the total 110 dollars. Remember that it costs another 10 dollars to sell. This means is that your stock has to grow 17% in value before you make a single penny in profit. If you think this sounds bad, lets look at diversifying.

You still have 100 dollars to invest and commissions are still 10 dollars per trade. However, you invest evenly into five companies. This is now five separate trades costing you 50 dollars. Since selling will cost you another 50 dollars your stock has to double before you see a single penny. Simply, the larger your trades the lesser commissions affect your profit.

Diversification protects you from risk, right? It may look like that, but if you calculate commissions as a loss, then the non-diverse portfolio can lose 33% of its value and still be even to the initial investment of a diversified portfolio. The commission on a diversified portfolio would be the same thing as if you payed face value for your shares, and watched them dive 50%. Doesn't feel too comfortable, does it?

Does this mean that you throw diversity out the window? I'd like to say yes, but if you're still want to be divested then buy index funds. Index funds are the easiest and most thorough way to be diverse, and since it's considered one trade, also the cheapest.

Stock Selection: Innovation

Vonage (NYSE:VG) and Verizon (NYSE:VZ) provide today's lesson on stock selection. My first stock review was on Vonage and I once owned shares of Verizon. My reasons for purchasing Verizon stock was the same as my reasons for not buying Vonage stock. Both companies are listed on the New York Stock Exchange, have perplexing names starting with "V", and share the same industry. If there ever was a telecom tale of two cities, this would be it. Coincidently, they were also sharing the same technology, Verizon's.

The first time I wrote about Vonage, I wrote that it needed a unique patented technology to survive competition. When I bought Verizon, it was because of Verizon's (GTE's and BBN's) track record for creating new technologies. Coincidently, a week after I bought Verizon, they unveiled their FIOS technology designed to compete with the encroaching cable industry. While I could not predict the future for either company, I knew that an innovative company is a growing company. Looking back, it's plainly clear to see that the value of both companies took the path they were destined to take.

When choosing a stock, it's important to keep in mind the company's repeated ability to reliably create successful innovations. Either new technologies, new products, or new markets. Change is constant, stagnation is death for a company. If you can handle the risk, look for really risky innovators, the greater the risk, the more life changing the results.

Also keep an eye out for companies that hide their innovations through subsidiaries. These are often used to mitigate risk to the parent company. If they subsidiary makes a successful innovation, then often it's absorbed or sold for a nice profit. If it fails then the parent can shed it off with little impact on its own reputation.

Be careful of those companies that got big off some innovations, but then used their cash to buy other innovative companies. Unless they purchase a company to do their R&D and not for its R&D. When GTE bought BBN, it purchased a strong R&D arm. When Google bought YouTube, it bought someone else's R&D. Yet, Google still maintains its own R&D with Google Labs, and fosters other projects with its Summer of Code program.