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diversification and the basics of stock market investing



5/27/2009
The practice of diversification is the worst piece of advice that I think can be given to investors. The ideas is to buy a bunch of stocks and try and keep your risk low i.e. diversifying. Nothing can be further from the truth as many people have witnessed with either though their 401k’s, mutual funds, or investment funds and retirement funds. It is true that the more companies you invest in the better chance you have of following the general trend of the stock market, but at the same time you can lose a fortune if the general markets start collapsing. The key to making a lot of money is simply owning a few good business and just a few of them will always do. Most business are not worth your money or time so remember that before you invest. The way to find just a few good businesses to invest your money into isn’t as hard as it sounds.

Firstly you find about 20 businesses that have a high enough ROE and low enough amount of debt before they should even be considered. Then you weigh in the management, their stake in the company, and what kind of moat the company has to make your final decision. Also the business that you buy must be for at least a fair price; determining what a fair price is isn’t easy but I can tell you what a fair price isn’t. Many of the stocks these days have a price to earnings ratio of like 30 which unless the company is asset rich with book value, then it is a totally absurd price to pay for a business. That means that technically you should get your money back in 30 years if the business keeps doing the same that it is. I know there are other factors to be taken into consideration like how well the business is doing in the future, but that’s just too risky for me. Think about it, would you buy a hotel generally speaking for 3 million, if it only made a net income of 100 thousand in a year? Basically that’s what people are doing when they buy stocks that have a price to earnings way beyond what they should. Remember the key to the game is to buy a few good businesses at a good price; you should have no more than 10 businesses and preferably 5 in your portfolio as this is one of the basics of stock market investing.

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diversification and a rally