Why Diversify?

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During the bull market of the 1990s, one of the most common criticisms of diversification was that it lowers your potential for high returns. After all, if you could identify the next Microsoft, wouldn’t it make sense for you to put all your eggs into that one basket?

Well, sure. As the humorist Will Rogers once said, ” Don’t gamble. Take all your savings and buy some good stock and hold it till it goes up, then sell it. if it don’t go up, don’t buy it.”

However, as Rogers knew 20/20 foresight is not a gift granted to most investors. No matter how confident we feel, there’s no way to find out wether a stock will go up until after we buy it. Therefore, the stock you think is the “next Microsoft” may well turn to be the next MicroStrategy instead. ( The former market star went from $3,130 per share in March 2000 to $15.10 at year-end 2002, an apocalyptic loss of 99.5%). ^1 Keeping your money spread across many stocks and industries is the only reliable insurance against the risk of being wrong.

But diversification doesn’t just minimize the odds of being wrong. It also maximizes your chances of being right. Over long periods of time, a handful of stock turn into “superstocks” that go up 10,000% or more. Money Magazine identified the 30 best-performing stocks over the 30 years ending in 2002- and, even with 20/20 hindsight, the list is startlingly unpredictable. Rather than lots of technology- or health-car stocks, it includes Southwest Airlines, Worthington Steel, Dollar General Discount stores, and snuff-tobacco maker USC Inc.^2 If you think you would have been willing to bet big on any of those stocks back in 1972, you are kidding yourself.

Think of it this way: In huge market haystock, only a few needles ever go on to generate truly gigantic gains. The more of the haystack you own, the higher the odds go that you will end up finding at least one of those needles. By owning the entire haystack ( ideally through an index fund that tracks the total U.S. stock market) you can be sure to find every needle, thus capturing the return of all the superstocks. Especially if you are defensive investor, why look for the needles when you can own the whole haystack?

^1 Adjusted for stock splits. To many people, MicroStrategy really did llok like the next Microsoft in early 2000; its stock gained 566.7% in 1999, and its chairman, Michael Saylor, declared that “our future is today is better than it was 18 months ago.” The U.S. Securities and Exchange Commission later accused MicroStrategy of accounting fraud, adn Saylor paidan $8.3 million fine to settle the charges.

^2 Jon Birger, “The 30 Best Stocks,” Money, Fall 2002, pp. 88-95

Author Benjamin Graham, The Intelligent Investor. The Definitive Book on Value Investing

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