Diversification; Goal is to lower portfolio volatility without sacrificing overall returns

This strategy helps reduce the risk profile of an investment as it spreads out the portfolio over multiple asset classes or sectors.

The goal of diversification is to lower portfolio volatility without sacrificing overall returns. In this way, investors can benefit from holding a combination of stocks and bonds, as asset classes tend to perform differently in varying market conditions.

Portfolios and Selling

#Good company gets inexpensive, how much to buy?

When an understood, good company gets inexpensive, we buy its stock. But how much?

(1)  Enough uninvested cash (CASH)
My rule is simple. Provided that I have enough uninvested cash, I put 10 percent of the portfolio in it. I’ve seen other good investors use infinitely more complicated guidelines, but none that I’ve found to be more practical.

If I’m not comfortable putting at least a tenth of the portfolio into an equity, I don’t want the equity. If my conviction is lower I don’t buy less, I buy none.

(2)  Strong conviction (COURAGE)
A strong conviction is important in part because right after a buy the price of a stock is almost certain to drop. That’s the corollary to another near-certainty: that the price paid for a stock is unlikely to be a low. Rock-bottoms don’t send out invitations. So knowing when one will happen is impossible. The astute investor counts on missing them.

Correspondingly, I prefer not to put more than a tenth of the portfolio into a single equity. This reduces the chance that I’ll lack the cash necessary to take advantage of other opportunities that emerge.



#Buying is one aspect of portfolio construction. Another is selling.

There are two problems with selling. 

1.  The first is taxes. 

The profitable sale of stock is taxable in most circumstances. Just how much this eats into long-term returns is best illustrated by example.

Picture two portfolios. Each starts with only cash, buys only non-dividend paying stocks, and liquidates after 30 years. Assume that any stock sales are subject to a total long-term capital gains tax rate of 30 percent.

Portfolio one uses all its cash to buy stock on the first day. It appreciates 15 percent before taxes every year. It doesn’t sell anything until the liquidation date, at which point it immediately pays any taxes due.


Portfolio two also uses all its cash to buy stock on the first day. It too appreciates 15 percent per year before taxes. But it churns its holdings annually. At the end of every year, it sells everything, and uses all the after-tax proceeds to instantly buy different stocks. When it liquidates after 30 years, it too promptly pays any taxes due.

Portfolio one would end the 30-year period with more money. But what’s striking is just how much more. It would wind up with over twice as much cash. That’s because every year when portfolio two paid its capital gains taxes, it whittled down the amount set to grow at 15 percent over the following year. In other words, ongoing tax payments stunted the power of compounding.

By contrast, portfolio one’s capital was never whittled down. It regularly got to multiply its 15 percent by a bigger number:

http://www.goodstockscheap.com/17.1.xlsx

Of course one could never count on an equity portfolio to appreciate at exactly 15 percent annually, and the chance of immediately finding stocks to replace just-sold ones is low. Plus the 30-year period is arbitrary, and a 30 percent tax rate doesn’t apply to everyone. But however simplified, this example
highlights the toll that frequent selling takes.


2.  The second problem with selling is alternatives. 

Companies that are understood and good don’t go on sale every day. They’re hard to find. So absent an acute cash requirement, each stock sale mandates a hunt for the next opportunity.



#When selling makes sense

Even with these problems, selling does makes sense in some instances. I see four.

(a)  The first is when price flies past value. 
If EV/OI is over 25, and there are no mitigating facts, I find it hard to justify holding.

(b) The second instance is when a company that originally registered as good turns out not to be. 
This could be because the original analysis was wrong. Perhaps the threat of new entrants was stronger than it first appeared, or a market thought to be growing really wasn’t. Or it could be because circumstances have changed. Maybe a once-mighty retail chain has come under pressure from online-only sellers, or a company that thrived under regulation has faltered in deregulation.

The cognitive bias of consistency can make it hard to see such instances. We may want to hold just to validate our buys. But analyses really can be wrong, and contexts really can change. Selling in such situations keeps a snag from ripping into both a realized loss and a missed chance to redeploy cash into a better opportunity.

(c)  The third instance is when one is bought out. 
Public companies sometimes get acquired. Such transactions often happen at a premium to the recent trading price. A vote may be put to shareholders on the matter, but for everyone other than major stakeholders, it’s perfunctory. One effectively has no say.

I’ve been bought out several times. I dislike it. It turns a pleasantly appreciating investment into a taxable event. But if profitable, given the absence of practical options, it makes sense to accept such sales.

(d)  The fourth instance is when cash is needed to make an investment that’s clearly better than one already held. 
The problem with this is that fresh ideas often glow with a special promise. They’re new. The hope bias gets a prime shot at causing mischief. As such, I get extremely suspicious of my reasoning when I think that I’m spotting such a circumstance. I’ve never actually sold one company for the specific purpose of buying another.



#When selling makes no sense

Two commonly cited reasons for selling puzzle me.

1.  One is rebalancing. 
It’s selling part of a stock holding because appreciation has caused it to represent a disproportionately large percentage of the portfolio.

Rebalancing makes sense to those who equate risk with total portfolio volatility. I don’t. So on the sell side, I’ve never seen the merits of this practice.

It makes more sense to me on the buy side, since unless part of a holding was sold, a decrease in its portfolio prominence means that its price dropped. One could now buy more of it cheaper. But on the sell side rebalancing looks to me like the anchoring bias in action.

2.  A second common reason for selling is to prove that an investment was a success (taking profits). 
The sale is seen as a sort of finish line. Underlying this perception is a view that cash is somehow more real than stocks.

It’s not. Cash and stocks are different forms that wealth can take. Unrealized gains are not endemically less concrete than realized gains. Selling doesn’t demonstrate investing competence any better than does intelligent holding.


Yet another reason for selling is Industry compensation
There’s an additional reason that selling happens. It relates only to institutional portfolios, like hedge funds. It’s about compensation.

Investment funds often pay managers 2 percent of assets under management per year, plus 20 percent of any gain above some hurdle. That 20 percent is applied to pretax returns. It’s blind to taxes. For this reason professionals may emerge as more enthusiastic about selling than would their limited partners. After all, unless they’re tax-exempt, the limited partners are the ones that come to bear the bulk of the tax liabilities born of the fund’s realized gains.

One faces great impetus to sell. It feels good. It’s conclusive. It turns the brokerage statement into a congratulations card. But it also triggers a tax expense and—short of a pressing need for cash—forces a search for the next underpriced equity.

When a sale is wise, its justification is distinct. It’s an overpricing, an analytical error, a contextual change, a buyout, or a better opportunity. Absent that clarity, I hold.



#Equity portfolio can generate cash through buyouts and dividends
Even without active selling, an equity portfolio can generate cash. It can do so in two ways.

1.  The first is through acquisitions, as mentioned earlier.

2.  The second is through dividends. 
Dividends can become sizable. This fact gets lost in the commonly quoted metric of dividend yield.

Recall that dividend yield equals annual dividends divided by current stock price. But to an owner, current only counts in the numerator.

When I first bought Nike stock, the dividend yield was around 2 percent. Over a decade later when I sold it, it was still around 2 percent. But by then my dividend yield—the current annual dividend divided by the price I’d paid for the stock—was closer to 10 percent. Dividends had gone up over time, but my cost hadn’t. That’s how dividends can become a booming cash source underappreciated by all but those who get them.



#Over time, good focused (concentrated) stock portfolios outperform diversified portfolios.
Remember that my portfolio is concentrated. It contains no more than a dozen names, and usually far fewer. On purpose, it’s not diversified. Many good equity portfolios are, but mine isn’t.


1.  Good focused portfolio versus diversified portfolio
I choose to concentrate because I’ve observed over time that good, focused stock portfolios outperform diversified stock portfolios. This is because diversified portfolios are more like an index. They have more names in them. The more a portfolio looks like an index, the more it behaves like an index. It’s hard to both resemble and outperform something.


2.  Bad focused portfolio versus diversified portfolio
Of course a bad focused equity portfolio can certainly lag a diversified stock portfolio.

Concentration isn’t enough to assure outperformance. But if it’s purposefully constructed, a focused group of inexpensively bought good companies is particularly promising.



#Sequestered Cash outside of the equity portfolio for  ordinary expenses 
While I don’t diversify within my equity portfolio, I do diversify outside of it. I always keep enough cash on hand to cover expenses for a few years. As I get older, I expect to increase this number of years.

1.  In Federally insured banks
This isn’t cash inside the equity portfolio waiting to be invested in stocks. It’s cash outside of the equity portfolio, held in federally insured banks. It will never be anything other than cash or spent.

Sequestering cash enables me to confidently ride the wild price swings guaranteed to come with a concentrated equity portfolio. It’s what lets me take the long view. When the price of my stock portfolio halved during the 2008 financial crisis, I didn’t panic. I knew that I could meet all of my expenses. There was no basis for panic.

Many governments insure bank deposits. Coverage varies by country. In America, the Federal Deposit Insurance Corporation generally guarantees up to $250,000. In the United Kingdom, the Financial Services Compensation Scheme stands behind £75,000. In Canada, the Canada Deposit Insurance Corporation backs C$100,000.

Because the whole point of sequestered cash is to avoid the scare that forces ill-timed stock sales, it’s wise to stay well under the insured limit. Opening up accounts at several different banks is not hard.


2.  In same currency as one's expenses Sequestered cash is best held in the same currency as one’s expenses. If it isn’t, foreign exchange rate fluctuations can hurt one’s ability to meet obligations.

As I write this, the British pound has slumped to a 30-year low against the U.S. dollar. This follows Britain’s decision to leave the European Union.1 Some American investors think the slump is overdone and have invested in the British pound.

To people whose expenses are in U.S. dollars, those pounds don’t count as sequestered cash. Instead, they count as a currency investment.



#These repositories for sequestered cash aren't really good
Two things that may look like good repositories for sequestered cash really aren’t.

1.   The first is certificates of deposit, or CDs. 

Outside of the United States they’re commonly called time deposits. They offer higher interest rates than do regular bank accounts. Money must stay in them for a predetermined period. If it’s withdrawn early, a penalty is applied that more than wipes out the extra interest.

If the CD interest rate is much higher than the regular interest rate, one could theoretically keep a portion of sequestered cash in CDs. The portion would have to be limited to that which shouldn’t be needed for the duration of the lockup period.

That said, I don’t use CDs. Since the timing of cash needs can surprise, I prefer to keep the focus of sequestered cash on costless accessibility.

2.   The other repository is cash-like funds (commercial paper). 
They too offer higher interest rates. An example is a fund that invests in commercial paper. Commercial paper is short-term notes issued by corporations.

Such cash-like vehicles usually behave like cash. One can pay bills with them. But I’ve seen instances when they don’t. During the financial crisis, an acquaintance of mine was surprised to learn that her financial institution had temporarily halted withdrawals from such a fund. She couldn’t make payments with it.

This potential—the inability to immediately liquidate—is the problem with these alternatives. The purpose of sequestered cash is to free one from worry during equity market gyrations. If what’s used for expenses ever can’t be used for expenses, that benefit is lost. One can wind up having to sell part of an equity portfolio when it’s underpriced, erasing the benefits of stock investing.


#Problems with cash
Cash has its own problems, of course. Inflation erodes its purchasing power over time. Expansionary monetary policies—governments printing money— exacerbate this. But if held in government-insured accounts under applicable limits, at least it’s always there. That availability is what makes the interim ups and downs of an equity portfolio’s price not only bearable, but almost trivial.





Summary
1. Conviction prepares one for the likely price drop that follows a stock buy.
2. Selling stocks can make sense 

• price flies past value, 
• when a company thought to be good turns out not to be, 
• in buyouts, or 
• when a clearly better opportunity emerges.

3. The problems with selling are taxes and alternatives.
4. Questionable reasons for selling include 

• rebalancing, 
• memorializing success, and 
• industry compensation.

5. Equity portfolios can generate cash without active selling through 

• buyouts and 
• dividends.

6. Good focused equity portfolios outperform diversified equity portfolios over the long term.
7. Cash sequestered for ordinary expenses in government-insured accounts makes equity portfolio price gyrations less troubling.


Reference:

Good Stocks Cheap by Kenneth Jeffrey Marshall 2017

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions.

Portfolio management requires paying attention to the portfolio as a whole, taking into account 

• diversification, 
• possible hedging strategies, and 
• the management of portfolio cash flow. 

In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors. 



1.  Appropriate Diversification 

Even relatively safe investments entail some probability, however small, of downside risk.

• The deleterious effects of such improbable events can best be mitigated through prudent diversification. 
• The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice. 

Diversification for its own sake is not sensible. This is the index fund mentality: if you can't beat the market, be the market.

• Advocates of extreme diversification - which I think of as overdiversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. 
• My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. 
• One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea. 

Diversification is potentially a Trojan horse. 

• Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. 
• The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky. 
• Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. 
• Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail. 

2.  Hedging 

Market risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging. An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.


A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures. 

• This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. 
• If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole. 

A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.

A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling  gold futures.

A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets. 



It is not always smart to hedge. 

• When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. 
• Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. 
• When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. 
• In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits. 

By way of example, from mid-1988 to early 1990 the Japanese stock market rose repeatedly to record high levels. The market's valuation appeared excessive by U.S. valuation criteria, but in Japan the view that the stock market was indirectly controlled by the government and would not necessarily be constrained by underlying fundamentals was widely held.

• Japanese financial institutions, which had become accustomed to receiving large and growing annual inflows of funds for investment, were so confident that the market would continue to rise that they were willing to sell Japanese stock market puts (options to sell) at very low prices. 
• To them sale of the puts generated immediate income; since in their view the market was almost certainly headed higher, the puts they sold would expire worthless. 
• If the market should temporarily dip, they were confident that the shares being put back to them would easily be paid for out of the massive cash inflows they had come to expect. 

Wall Street brokerage firms acted as intermediaries, originating these put options in Japan and selling them in private transactions to U.S. investors.' These inexpensive puts were in theory an attractive, if imprecise, hedge for any stock portfolio.

• Since the Japanese stock market was considerably overvalued compared with the U.S. market, investors in U.S. equities could hedge the risk of a decline in their domestic holdings through the purchase of Japanese stock market puts. 
• These puts were much less expensive than puts on the U.S. market, while offering considerably more upside potential if the Japanese market declined to historic valuation levels. 

As it turned out, by mid-1990 the Japanese stock market had plunged 40 percent in value from the levels it had reached only a few months earlier.

• Holders of Japanese stock market put options, depending on the specific terms of their contracts, earned many times their original investment. 
• Ironically, these Japanese puts did not prove to be a necessary hedge; the Japanese stock market decline was not accompanied by a material drop in U.S. share prices. 
• These puts were simply a good investment that might have served as a hedge under other circumstances.

The intelligent and safe way to handle capital is to concentrate.

Diversification

The beginner in investing needs diversification until he learns the ropes.

Diversification is an admission of not knowing what to do and an effort to strike an average.



Concentration is the intelligent and safe way

The intelligent and safe way to handle capital is to concentrate.

If things are not clear, do nothing. 

When something comes up, follow it to the LIMIT.

If it is not worth following to the limit, it is not worth following at all.



How to start?

Always start with a large cash reserve.

Next, begin in one issue in a small way. 

If it does not develop, close out and get back to cash. 

But if it does do what is expected of it, expand your position in this one issue on a scale up. 

After, but not before, it has safely drawn away from your highest purchase price, then you might consider a second issue.




Greatest Safety:  Putting all your eggs in one basket and watching the basket

The greatest safety lies in putting all your eggs in one basket and watching the basket.

You simply cannot afford to be careless or wrong. 

Hence, you act with much more deliberation.

Of course, no thinking person will buy more of something than the market will take if he wants to sell, and here again, the practical test will force one into the listed leaders where one belongs. 

The less active a stock and the further distant the market, the more potential profit I need to see in it to make it worth buying.

It is purely a personal matter whether an investor feels that efforts at safety are more important than trying to get the maximum out of investing.



Stocks in the same business cycle

Diversification between the position of varying companies in their business cycle or as between their shares in their market price cycle is a very important consideration. 

Dividing one's funds between three or four different stocks which happen all to be in the same sector of their cycle can often be discouraging or dangerous.

After all, the final determinant of investment success or failure is market price.

• For example, industries which are in the final stages of a boom with rapidly increasing earnings, dividends and possibly split-ups, often offer shares high in price but apparently rapidly going higher.  There is a sound justification for an investor who knows what he is doing to buy into such a situation, especially for short-term gains, but it would be quite dangerous for him to put all of his funds in three or four such stocks.

• On the other hand, we naturally all seek deflated and cheap bargains, but very often shares like this will lie on the bottom much longer than we anticipate and if every share we own is in this same category, we may do very badly in a relatively good market.

Conclusions:

The greatest safety for the capable, lies in putting all one's eggs in one basket and watching the basket.  

The beginner and those who simply find their investment efforts unsuccessful must resort to orthodox diversification.

Smart diversification is the key. The smart investors are focus Investors.

True investors are not random stock pickers.

They take out risk by understanding the investments and their intrinsic value, rather than by spreading the risk across more companies.

Smart investors are focus investors who drive toward deep understanding of their investments without diluting possible returns through diversification.

They see danger in owning too many investments, which may be beyond the scope of what they can manage or keep track of.

Here's the paradox:  Instead of reducing risk through diversification, risk may actually increase as it becomes harder to follow the fortunes of so many businesses.

That is why Buffett and others reject diversification per se as an investment strategy.

They prefer to reduce risk by watching a few companies and investments more closely.


"Diversification is for people who don't know what they're doing."  Warren Buffett.

Focus investor and Risk

In contrast to the diversified stockholder, the focus investor will ordinarily demand a significant margin of comfort prior to allocating substantial funds to a single stock. Fear of loss can concentrate the mind wonderfully, and the investor staking a large proportion of his or her total funds on only one security is more likely to rigorously scrutinize this potential investment.

As Buffett summarizes, a policy of portfolio concentration should serve to increase “both the intensity with which an investor thinks about a business and the comfort-level he must feel
with its economic characteristics before buying into it.”

Focusing on only a handful of stocks should not, therefore, increase portfolio “ risk,” at least as it is defined by the layperson—that is, the possibility of incurring financial loss.

• The intelligent investor will only select those stocks that exhibit the largest shortfall between quoted price and perceived underlying value—that is, those securities that are likely to provide the greatest margin of safety against financial loss in the long term. 
• Although a compact suite of stocks will be undeniably more volatile than a diversified holding, short-term price fluctuations are of little concern to a long-term holder of stocks who focuses on income rather than capital appreciation.
• Indeed, value investors favor those stocks that display the potential for extreme volatility— the difference is that these investors expect predominantly upside volatility.

Risk, for value investors, is not a four-letter word—it is embraced and addressed proactively, not defensively

Portfolio concentration can produce better results than diversification.

Portfolio concentration can produce better results than diversification due to a number of factors, including 

• lower transaction costs—broker commissions proportionately decrease as deal size increases— and
•  potentially lower administration costs. 

But perhaps the most compelling argument for portfolio concentration by informed investors is the simple logic expressed in one of Warren Buffett’s shareholder letters:

I cannot understand why an [educated] investor . . . elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices—the businesses he understands best and that present the least risk, along with the greatest profit potential. 

The same impulse that propels stock market speculation also motivates the drive toward diversification—the desire to be part of the crowd.

As the financier Gerald Loeb recognized, a widely diversified portfolio “is an admission of not knowing what to do and an effort to strike an average ” —for those investors who believe that they can in fact rank stocks, a policy of portfolio concentration is preferable.  

Keeping It Simple
Diversification is, in reality, more a strategy of risk dispersion than risk reduction.

Keynes’ response to uncertainty and risk in the share market was radically different to the prevailing wisdom—as he explained in a letter to one of his business associates:

 . . . my theory of risk is that it is better to take a substantial holding of what one believes shows evidence of not being risky rather than scatter holdings in fields where one has not the same assurance.

To ascertain which stocks “show evidence of not being risky,” the value investor searches for those securities that exhibit a sufficiently large margin of safety—that is, those stocks with a substantial gap between estimated intrinsic value and the quoted price.

In undertaking this analysis, the intelligent investor will necessarily focus only on those businesses he or she understands. Keynes noted that he would prefer “one investment about which I had sufficient information to form a judgment to ten securities about which I know little or nothing.” His contention was that intelligent, informed investors will reduce their downside risk by scrutinizing only those sectors within their “circle of competence” —to use Buffett’s phrase—and then only investing in those stocks which exhibit a satisfactory margin of safety. 

Like Socrates, the intelligent investor is wise because he recognizes the bounds of his knowledge  

Time is your friend. Time smooths out volatility.

Historically, time smooths out volatility.

The longer you stay in the market, the more likely you are to see your investment do what it should.

The range of returns narrows when we hold our investments for a longer period of time.

Even the most volatile asset class, that is, stocks, becomes relatively stable when you take the long view.

If you have a reasonable time horizon, you have an excellent chance of high average returns over many years.
That translates into a comfortable portfolio with plenty of cushioning along the way.

What if you are approaching retirement or you are already in retirement?

How can you get the returns you want while minimizing the volatility you don't want?

The answer:  diversify.

Beginner Strategies for Investment

Investment strategies aren't just about picking the best investments you can find, but about picking investments that are more beneficial together than they are on their own.

Here are some basic strategies to build your investments.

The most common strategy is simple diversification of investments.

For bonds, this means staggering your coupon and maturity dates not only to provide consistent income but also so that you can more readily respond to changes in the market, rather than having the entirety of your bond investments tied up at the same time.

For stocks, this means picking high-quality investments which tend to fluctuate in price in opposite directions; as one stock decreases in value in the short run, another should increase, but both should appreciate over the long run.

In the same manner, including global diversification of stock investments can reduce the impact of global trends.

Diversifying into types of investment you have can help you find an appropriate balance of potential gain and risk - maintaining a percentage of your portfolio in stocks or even high-risk investments like speculative stocks or junk bonds and the remainder of your portfolio in low-risk investments.



Options

Many options make use of a combination of stocks and derivatives.

Buying stocks as well as a put option gives you the upside potential of the stock but limits your potential losses by guaranteeing you will be able to resell the stock at the price noted in the option.  So long as your gains exceed the purchase cost of the put option, you will remain "in the black".

If you believe a stock will decrease in price, you can sell it short and then buy a call option, so that if you are wrong you can repurchase the stock at a guaranteed maximum price, putting a limit on the immense risk associated with shorting stock.

Buying both a call and a put option with the same strike price (the price at which you can exercise your option) means that you will make money regardless of which direction the stock moves, so long as the move is large enough that you earn more money than the cost of the options.  This strategy is known as a "straddle".

In a strategy known as a "collar", you buy a stock and sell a call option on the stock , so that if the price of the stock increase, the option buyer will likely exercise their option; this creates limited upside potential, but the money from the sale of the call option can be used to fund a put option, so that you eliminate the cost of the option.  The result is that you create both a "floor" and a "cap" (a maximum amount of loss and gain, respectively), functioning as a collar that limits the amount of movement in the stock price.

The strategies available to you are varied and numerous.  As you get more practice using them, you can expand to develop multi-step strategies.




[Diversification:  The act of investing in several different investments to reduce the potential value of loss if a single investment fails.

Buying a call option gives you the choice to purchase a given volume of something at a specified price, so long as you do so before the maturity date.

Buying a put option gives you the choice to sell a given volume of something at a specified price.

Regardless of what happens to the market price, the seller of the option is obligated to participate in the exchange if the buyer decides to exercise the option.]

Buying Good Quality Stock versus Buying Poor Quality Stock

Graham, Chapter 20:

Chapter 20 is entitled "Margin of Safety as the Central Concept of Investment" (p. 512). I think this chapter sums up Graham's investing philosophy. 

He not only covers the risk of buying a good quality stock at a high price, but buying a poor quality stock at a high price during an up-trending market. The latter is one of the riskier moves you can do with your money in the context of the margin-of-safety. On the other hand, purchasing stock in a good quality company, even if it's at a high price, will ultimately end up being the better choice.

One other important point in this chapter is the mention of diversification as a tool of safety, not perfection. While he doesn't go into specific methods of diversification, Graham does point out that even if one stock tanks, diversifying your portfolio "guarantees only that (you) have a better chance for profit than for loss - not that loss is impossible" (p. 518).

Intelligent Investor 

by Benjamin Graham

Main lesson:  

Buying a poor quality stock at a high price during an up-trending market is one of the riskier moves you can do with your money in the context of the margin of safety.   AVOID.  AVOID.  AVOID.

How to diversify

You can diversify your investments at a number of different levels:

• across companies
• across industries
• geographically
• across asset classes.

If you want to diversify while still keeping your portfolio manageable, you should consider pooled investments.

It is unwise to spread one's funds over too many different securities.

It is unwise to spread one's funds over too many different securities.  Time and energy are required to keep abreast of the forces that may change the value of a security.  While one can know all there is to know about a few issues, one cannot possibly know all one needs to know about a great many issues.  

Diversification - or concentration - of an investment portfolio directly correlates with the amount of time and energy put into making the selections.  The more diversification, the less time for each decision.  

"Diversification is a protection against ignorance.  It makes very little sense for those who know what they're doing."  -   Warren Buffett

Diversification and fear of risk

Fear of risk is a legitimate fear - it is the fear of losing money.

Master investors don't fear risk, because they passionately and actively avoid it.  Fear results from uncertainty about the outcome, and a master investor only makes an investment when he has strong reasons to believe he'll achieve the result he wants.

Those who follow the conventional advice to diversify simply don't understand the nature of risk, and they don't believe it is possible to avoid risk AND make money at the same time.  

While diversification is certainly a method for minimizing risk, it has one unfortunate side-effect: it also minimizes profit.

Five Basic Fundamental Investing Principles

History has demonstrated that there are five basic principles that 
you should follow if you want to be truly successful.

Invest Regularly in the Stock Market

Reinvest all of Your Profits and Dividends

Invest for the Long Term

Invest Only in Good Quality Growth Companies

Diversify Your Portfolio

5 Tips for a Better Stock Portfolio (Morningstar)

Very few people have gotten rich on their 7th best idea. You'd be much better off putting more money into your best idea.

Warren Buffett:

"There are a lot of things you can learn if you are around securities over the course of your career, and you will find a lot of arbitrage opportunities. However, that probably won't be the primary driver of your investment returns.

If you are not a professional investor, then you should be extremely diversified and you should do very little trading. However, if you want to bring an intensity to the game, and you are going to value businesses, then diversification is a terrible mistake. If you really know business, then you shouldn't own more than 6 businesses. Very few people have gotten rich on their 7th best idea. You'd be much better off putting more money into your best idea. "

20 Investments

Most people will find that their investment objectives change throughout their lives. Capital appreciation may be more important for the young investor, but once she enters her golden years, that same investor may place a greater emphasis on gaining income. Whatever your objective, knowing what investment options are out there is key.

Table of Contents

1. 20 Investments: Introduction
2. 20 Investments: American Depository Receipt (ADR)
3. 20 Investments: Annuity
4. 20 Investments: Closed-End Investment Fund
5. 20 Investments: Collectibles
6. 20 Investments: Common Stock
7. 20 Investments: Convertible Security
8. 20 Investments: Corporate Bond
9. 20 Investments: Futures Contract
10. 20 Investments: Life Insurance
11. 20 Investments: The Money Market
12. 20 Investments: Mortgage-Backed Securities
13. 20 Investments: Municipal Bonds
14. 20 Investments: Mutual Funds
15. 20 Investments: Options (Stocks)
16. 20 Investments: Preferred Stock
17. 20 Investments: Real Estate & Property
18. 20 Investments: Real Estate Investment Trusts (REITs)
19. 20 Investments: Treasuries
20. 20 Investments: Unit Investment Trusts (UITs)
21. 20 Investments: Zero-Coupon Securities
22. 20 Investments: Conclusion

Read more: http://www.investopedia.com/university/20_investments#ixzz1xvXipPW4

Concentrated Ideas

"Wide diversification is only required when investors do not understand what they are doing."

-  Warren Buffett


Note:  Focus concentration of about 10% in each stock.  Anything stock that is less than 5% may not be worth your effort.

How To Improve Your Value Investing Returns

Do you really have the courage of your own convictions?

If you're a value investor, how concentrated is your portfolio? And how concentrated do you think it should be?

This is a tough call. The more concentrated, the riskier, but the better your potential returns, of course.

It all depends how and where you're finding that value and how conspicuous it is. If you found during last year's slump, for example, that you lost a huge percentage of your wealth on paper, then you may be too concentrated. The receding tide took almost all boats with it. Then again, if you had the courage of your value convictions and had done all the research you possibly could, perhaps this was an averaging down opportunity?

As Warren Buffett has said: "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market." And as his partner Charlie Munger says, proper allocation of capital is an investor's number one job.

Decide what is right for you

So it's important to get share allocation right in the first place -- and at a level that is right for you.

I've looked before at whether there's a correct number of stocks to own, which also spawned a useful debate; each to his own here. No-one else can really make this decision for you. But if you're too diversified, you're unlikely to beat the market.

Warren Buffett's value investing mentor, Ben Graham, wrote of a portfolio strategy with a mixture of shares and bonds with a maximum of 75% shares and 25% bonds when share prices are low and demonstrating good value -- and vice-versa (25% shares, 75% bonds) when share prices are high.

Often, investors not sufficiently diversified and overly confident in the good times suffer scary losses in the bad and are unable to take advantage of buying opportunities due to insufficient funds.

The problem is made worse by the inherent psychological tendency many investors are shown to have of being too quick to take small profits and to run with the herd. Whereas, with true value stocks (profitable companies with solid assets and cash, priced well below price to tangible book value) you certainly don't want to be a forced seller. Instead, the opposite is true; you want to be able to take advantage of generalised market sentiment taking the price illogically lower.

Of course, it may well be that there has been news that shifts a company's intrinsic value, which then needs to be reassessed. If the margin of safety is no longer sufficient, then it may have to be sold at a loss; not all value shares come good, and this is a vital consideration.

Improving your value returns

I was interested to read a paper on value investing by Schroder from last November (a PDF). It makes for fascinating reading and demonstrates what value investors already know to be true.

Here are a few brief insights:

• What you pay, not the growth you get, is the biggest driver of whether you make money.
• Focus on exploiting what we CAN know (valuation) and not what we CAN'T (the macro).
• Focus on areas that offer compelling value -- the greatest driver of long-term returns.
• Being different is usually uncomfortable but often profitable.
• Understanding balance sheet risk and income growth is as important as a high yield.

Interestingly, as an aside, the paper also looks at contrarian sectors offering best value from last September, with Homebuilders, Insurance and Banks seeming to offer the best opportunities.

Andrew Tobias advised (as paraphrased by Peter Lynch): "Don't put all your eggs in one basket. It may have a hole in it." Instead, Lynch urges private investors not to rely on a fixed number of stocks, but to investigate how good they are on a case-by-case basis. He goes on to advise us: "In small portfolios, I'd be comfortable owning between three and ten stocks." Of course, he was more interested in earnings growth than out and out value.

The bottom line for me is that a value portfolio should be concentrated into a few well-researched shares, but not at the cost of too much risk, as I like to sleep at night.

http://www.fool.co.uk/news/investing/2012/04/04/how-to-improve-your-value-investing-returns.aspx?source=ufwflwlnk0000001

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

There is a seeming disparity of views between Graham and Buffett on diversification. 

• Benjamin Graham was a firm believer, even in relation to stock purchases at bargain prices, in spreading the risk over a number of share investments. 
• Warren Buffett, on the other hand, appears to take a different view: concentrate on just a few stocks.

WHAT WARREN BUFFETT SAYS ABOUT DIVERSIFICATION

In 1992, Buffett said that his investment strategy did not rely upon spreading his risk over a large number of stocks; he preferred to have his investments in a limited number of companies.

‘Many pundits would therefore say the [this] strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it.’

NO REAL DIFFERENCE BETWEEN BENJAMIN GRAHAM AND WARREN BUFFETT

The differences between Graham and Buffett on stock diversification are perhaps not as wide as they might seem. 

• Graham spoke of diversification primarily in relation to second grade stocks and 
• it is arguable that the Buffett approach to stock selection results in the purchase of quality stocks only.

BERKSHIRE HATHAWAY HOLDINGS

In addition, consideration of Berkshire Hathaway holdings in 2002 suggests that although Buffett may not necessarily believe in diversification in the number of companies that it owns, its investments certainly cross a broad spectrum of industry areas. They include:

• Manufacturing and distribution – underwear, children’s clothing, farm equipment, shoes, razor blades, soft drinks;
• Retail – furniture, kitchenware
• Insurance
• Financial and accounting products and services
• Flight operations
• Gas pipelines
• Real estate brokerage
• Construction related industries
• Media