Diversification is an established method for reducing investment risk. It comes from the work of Harry Markowitz and Modern Portfolio Theory. It's only common sense that if you have your wealth in only a few investments that you're facing more risk than somebody who has their money spread out over many different investments.

The usual reply to that is -- hey, this company is the greatest thing since Thomas Edison founded General Electric. It's going to outperform Wal-Mart, Microsoft and IBM put together.

Maybe -- but you don't know the future. No matter how bright a company's prospects seem, there's always risk.

The product which you think is a sure-thing fails in the marketplace.

The founder dies of a heart attack.

A terrorist attack destroys the company's world headquarters.

The Vice President of Marketing could be busted for sale of controlled substances.

A government agency finds the company guilty of law-breaking.

The company is hit with a huge class action lawsuit.

The company's main plant in Central America is confiscated by a socialist government.

And so on. The possibilities are endless. It's a virtual certainty that every company you consider investing in -- no matter how terrific its long term prospects appear -- will face difficulties of one sort or another. You won't truly know whether it's the next Wal-Mart or McDonalds until you see how it solves or fails to solve those problems.

The danger you face from investing in one company and depending upon it to survive and thrive despite its problems is called non-systemic or idiosyncratic risk.

So the obvious solution is to invest in two companies. If one fails, the other is still likely to succeed. However, there's still a high likelihood that both companies will fail. This is especially true if they're in the same industry. With the introduction of the automobile, all horse buggy companies failed, the well managed as well as the poorly managed.

So the logical answer is to invest in a number of different companies in various industries.

Modern portfolio theory determined that if you invest in 20 different companies in different industries you eliminate about 90% of the non-systemic risk. If you invest in 30 companies, you eliminate all systemic risk.

That means your only risk is what's called "market" risk -- that all 30 companies go down due to macroeconomic factors such as high interest rates or a worldwide depression.

However, there is a flip side to eliminating non-market risk, and that's eliminating non-market GAIN. That is, when you have 30 or more stocks you won't lose more than the market as a whole goes down, but your portfolio as a whole won't go up more than the market either.

Out of your 30 stocks, a few will go up big time, many will do average, and a few will go down. So the average will be pretty close to the market as a whole.

Now think about actively managed mutual funds. Most of them have stocks in from 30 or more companies. Most of them don't beat the market. They don't hang on to the stocks they pick. They sell some, making you pay taxes on the winners, and buy some, making you pay transaction costs. Not to mention that you pay the costs of your fund manager's salary and other administrative expenses which may be relatively cheap (Vanguard, for example) or expensive (most mutual fund families).

The obvious conclusion is that you have a choice between eliminating non-systemic risk by buying and holding a basket of 30 or so stocks in your brokerage account (NOT a mutual fund, where active management will cost you transaction and management fees, plus capital gains taxes) or taking the risk of choosing a few companies you're sure will take off like a rocket, and keeping your fingers crossed.

(One easy way to do as well as the market is to put your money into an index mutual fund such as Vanguard's S & P 500 index fund. That way you'll know you'll match the market -- which is better than 90% of actively managed mutual funds.)

Stock pickers hate this.

That's anybody who's trying to sell you their services of telling you what stocks are going to be winners: mutual fund managers, portfolio managers, brokers, newsletter writers, and financial analysts.

They love to look for companies that seem headed to success, and quite often they find them. If you put all your money into one company and it soon doubles or triples in value, you've beaten the market.

But remember, if all your investment funds are tied up in one or a few companies, you are faced with that non-systemic risk. If the company doesn't have the success the advisor thought it would -- your portfolio craters.

But surely there are good reasons why some companies succeed and others fail, and if you can isolate those reasons, you can buy the stocks most likely to succeed and avoid those most likely to fail.

This is has been the subject of much study, and in truth, there are proven indicators you can use to isolate companies more likely to be good investments. Two great books on this are: WHAT WORKS ON WALL STREET by James P. O'Shaughnessy and YES, YOU CAN TIME THE MARKET by Ben Stein and Phil DeMuth.

These authors have found long-term value in investing in stocks that have: low P/E ratios, high dividend yields, low price-to-book ratios, low price-to-cash flow ratios, and low price-to-sales ratios.

However, it should be noted that their studies involved groups of companies (O'Shaughnessy used the top 50 stocks in each criteria). None of them claim they've found a way to guarantee success in buying individual companies.

Of course, the prices of all stocks in the market can tank a la 1929, which is you should also be diversified across asset classes -- called asset allocation. Ideally, everybody should own some stocks, some cash (money markets or certificates of deposit), some real estate (besides your own home), and some bonds.

Ideally, you should own not only investments in your own country, but stocks, cash, real estate and bonds on every continent (except -- so far -- Antarctica!). This diversifies you across national and regional economies, and across currencies.

So whenever you hear someone deride diversification by making it "diworsification" (how cute) I'd bet some money (not all of my money, but some of it), that they're a broker or other advisor trying to sell you one particular company -- or else an advisor trying to sell you their particular method of picking winning stocks.

Would you rather base your financial future on one company which probably also means on one flawed, mortal person -- or upon the broad economic activity of your country or the world?

Copyright 2007 by Richard Stooker

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