Wednesday, September 19, 2012

Rule #18 Don't Diversify... too much.

This one goes against what most Financial Advisors will tell you.  They will tell you that you should diversify among various sectors and investment products because it allows you mitigate the risk of losing all your money if one event wipes out one of those sectors.  This is the "Don't put all your eggs in one basket" approach, except advisors tell you to put your money into lots and lots and lots of baskets by investing in multiple Mutual Funds or ETFs.  I am not a fan of "blanket across the board" diversification like this.  I would rather invest in 3-5 things or sectors that do I understand rather than hundreds that I don't - which is what most people are doing when they buy a broad-based mutual fund or an ETF.

I'm not against diversification per se, but I think hundreds of stocks are too many and is investing "not to lose" rather than investing "to win".  I also have the ambition to learn how all these companies operate and run their businesses, and invest in the ones that meet my risk tolerance level and long term investment plan.  I want the best companies for us, rather than buying a basket of stocks that include both the good and the bad.  Also, since I focus on cash-flow and not capital appreciation as the backbone of our strategy, I prefer to track financial statements of specific companies rather than of indexes where the data is more difficult pick out exactly whats happening to individual stocks.

Here is my rationale for taking a more focused approach.  It works for us, it may not work for everyone.  Have you ever heard of folks who invest solely in "Bricks and Mortar" Real Estate?  I have, and they often do quite well for themselves.  They have focused on learning the ins and outs of real estate investing and put all/most of their eggs in that basket.  Thats how real estate barons like Donald Trump make their fortunes.  They focus on one sector and do it very well.  I know other people who work in the High-Tech sector and they are constantly checking out their competitors and are aware of all the new trends developing within the sector.  Should they diversify in things they dont know or should they invest in what they know and live every day?  Mining Geologists I know invest in precious metals because they understand the supply and demand dynamics of the commodities industry better than anyone else.  All of these types of focused investors leverage their day-to-day professional knowledge towards their personal investments.  They have become experts in their fields and then apply that expertise to further their personal wealth through continuing to investing in their field of work.  Another way to approach or look at this is to invest in what interests you or what you understand based on your day-to-day experiences.  Does it makes sense to invest in hundreds of stocks that you don't understand or a select few that you do? I choose the latter.

I spent 17 years studying and working in the technical side of the Oil and Gas industry. I worked as a specialist for a Super-Major Oil and Gas Operating Company that explored for, and developed, hard-to-get-at resources.  Its a highly competitive industry and there are lots of players in both the Operating Company side as well as the Service Company side.  I understand many of these aspects of the industry because I lived it day-in and day-out for many years.  I still know people working at many of the companies and I am in communication with many of them on a regular basis.  Would it not make sense that I leverage that knowledge towards my investing practices?  I would think so.  I am also generally interested in money management, economics and wealth creation... and I am continually reading up on books about this kind of stuff, because thats what I'm genuinely interested in.  I am also interested and have some experience in the real estate market as we have owned 3 different properties in the past, and made offers on three other real estate deals that did not go through.  I've seen how these industries operate, studied them more, and understand them better than others.

Based on my expertise and interests I have chosen to invest in about 15-20 stocks in 4-5 sectors with respect to equities.  Those main sectors are: Oil and Gas, Commercial Real Estate, Energy Transport and Transmission (pipelines and electricity), Consumer Staples, and Banks/Financials.  I specifically do not invest in a number of sectors because I either don't like the sector itself, or because I don't understand how the businesses work or what their prospects are in the future.  Those sectors would include high-tech, retail, pharmaceuticals, consumer discretionary, transportation, commodities and agriculture.  I am slowly educating myself on a few of these sectors but until I understand them, I am in no rush to buy into them.

So as you can see, I am not against diversification because my portfolio is diversified, just not diversification to the point where I can't tell whats going on.  I like to invest in things I understand, and not invest in things that I don't.  Every investor has to determine what level of diversification is comfortable for them and how much they really need to know.

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