Sell low, buy high

By DAVID MOON, Moon Capital Management
August 10, 2003

If there was a lesson investors learned from the collapse of the technology bubble it was to diversify. Don't be too heavily invested in a single area; that could be the one that blows up and wipes out your retirement nest egg. You ought to own several investment styles. Growth, value, small-cap. International. Extra terrestrial. Even better, you ought to own several asset classes - just to spread your risk.

People learned the wrong lesson.

Diversification was not the lesson of the market collapse that began in 2000. The lesson was about value. The problem was that people bought overpriced assets, not too few asset classes. Investors, particularly institutions, use diversification as a replacement for knowledge about the things they own. If you don't know much about the things you own, you might as well own a little bit of everything. But diversification isn't a good replacement for knowledge. It gives people a false sense of comfort and security.

After watching their stock portfolios decline 30, 50 or 70 percent, many investors became instant fans of diversification. Diversity, diversity, diversity. Sell some stocks and move to bonds. Bonds were safe; stocks were risky.

Can you say "sell low, buy high," boys and girls?

Selling stocks at five-year lows, these new disciples of diversification put their money into supposed risk-free bonds. After all, what could go wrong if you owned a Treasury bond?

Plenty. In the last two months, many bonds and bond funds declined more than 15 percent. Rates are up, so prices are down.

Many investors now hold lower yielding bonds, the value of those bonds has declined significantly and new bonds offer much more attractive yields. But the worst part of the saga is that many of these investors sold stocks to buy those bonds. They were diversifying. They thought they were being smart. They were trying to avoid their mistakes of the late 1990s.

All they did was repeat those mistakes.

The mistake investors made in the years leading up to the collapse of the technology and large cap stock bubble wasn't a lack of diversification. The two major mistakes were ignoring the underlying value of the investments and having an inappropriate asset allocation. Folks had too much in stocks ' and the stocks they owned were overpriced.

An investor's asset allocation ' how much they have in stocks, bonds cash, etc. ' ought to primarily be a function of personal factors. Things like their risk tolerance and need for growth and income. Within each of those asset classes, however, investors must focus on the value of the individual securities (or mutual funds) they buy. Every asset is worth something. When you ignore the value of an asset, it makes no difference if you own 100 stocks or 50 mutual funds. Time is your enemy. You are speculating. You are guessing.

Concentrating your money into only a handful of investments exposes you to unneeded risk. Some diversification is wise. But Mae West was wrong; too much of a good thing isn't always wonderful.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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