Diversify yourself into mediocrity

By DAVID MOON, Moon Capital Management
January 14, 2007

Someone recently showed me a letter from an investment consultant about diversification. The letter noted that various investment styles go in and out of favor, so prudent investors always have some of their money committed to multiple styles, just to be safe.

To help prove the point, the letter was accompanied by an impressive chart. I knew it was impressive because it was in color and had pictures and words that were so small that I needed a magnifying glass to read it.

The impressive letter that was accompanied by the impressive color chart said, in part: '[S]tock groups go in and out of favor without much logic or warning,' and that's why diversification is so important.

This firm recommended that the foundation it was discussing expand its list of investment managers to include experts in a bunch more investment styles.

For a fee, you can hire this consultant to manage all of the managers you need to hire in order to be 'properly diversified.'

But hold on.

To evaluate the statement about stock groups going in and out of favor, you must first define what a 'stock group' is. It's pretty easy to differentiate between a large- and a mid-cap stock, but is there such a thing as a group of 'value stocks' or 'growth stocks?'

Sure, lists exist, but I wish someone could give me the ultimate list, so I could know where to look for investment ideas.

The terms 'value' and 'growth' mean whatever a particular investor chooses for them to mean ' or whatever a consultant tells you they mean. And for a fee, I know a consultant you can hire to provide definitions of these terms and select managers to fit into each of those boxes.

The impressive letter was correct about shifts in market dynamics occurring without much warning. But that's not the same as saying that these shifts are without logic.

Most inflection points in the market are the result of perfect logic ' that is, investors are correcting previous valuation mistakes.

Why do large-cap stocks sometimes outperform small-cap stocks over long periods? Almost certainly it's because companies that comprise the large-cap group are inexpensively priced relative to companies in the small-cap group.

Market changes can ' and do - occur without warning and often in reaction to irrational triggers. But the underlying cause is that some stocks are simply more attractively priced than others ' and price eventually reflects value.

Sometimes small caps are cheaper. Sometimes large caps are. Sometimes it's foreign stocks. Although plenty of people profess to be able to predict these inflection points, I've never seen anyone consistently do it.

I have, however, seen people who have consistently recognized the conditions necessary for a stock group to move in or out of favor. It's a function of price and value.

Some find it comforting to own what's in favor. I would much rather always own what is attractively priced.

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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