Al Frank (3)

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We ended the last blog with Mr. Frank's comments on diversification; i.e., not putting all of your eggs in one basket.  This mirrors the advice of the other authors we have looked at, Philip Carret and Benjamin Graham.  Al Frank stated that there are actually two types of diversification which the individual investor has to keep in mind.  In his book, Al Frank's New Prudent Speculator, he discussed the concept of diversification as follows:

There are two distinct schools of portfolio construction and management which can be summarized by the terms concentration and diversification.  Those who favor concentration believe in owning relatively few stocks at any one time.  Instead of putting many eggs in many baskets, the concentrationists put a few eggs in one basket.  They are very careful in the initial selection process, because if they are wrong in even one stock the impact on their equity would be significantly detrimental.  Some of them also believe that few can adequately analyze and understand more than a handful of corporations, let alone keep sufficient tabs on them after buying them.

Mr. Frank identified Gerald Loeb and Warren Buffet, two famous investors, as proponents of concentrated investing.  Although he obviously respected their investing track records, he did not agree with them.  He explained his position as follows:

In contrast to these estimable and successful gentlemen, I am a firm believer in diversification - almost the wider the better - in order to minimize individual corporate risk sometimes called unsystematic risk (as contrasted to market or systematic risk).  Even before I learned about risk reduction from diversification, I had an intuitive or common sense notion that if you only had a small percentage of your estate at risk in any one position, and if that position went against you badly, then you wouldn't be hurt much overall.  My initial sense of stock diversification was that I'd want at least 30 stocks, because 30 was the number that elementary statistics texts claim is a minimum meaningful population or number of events.  I find it interesting that my original, naive choice of having at least 30 stocks would turn out statistically to eliminate about 96 percent of individual stock risk.

Mr. Frank went on to warn his readers that just buying any 30 stocks was not the end of the exercise.  Those stocks had to also be in different industries; industries that did not, as a group, perform in similar ways in the market.  As an example, the oil exploration industry and the oil refining industry are connected for obvious reasons.  Economic events in the world will affect both industries in much the same way.  Indeed, events in one industry will have direct economic effects on the other.  Therefore, to own the stock of Exxon Mobil, the oil exploration giant, and also of Valero Energy Corporation, one of the largest oil refiners in the US, does not mean that the investor has achieved any meaningful diversification.  Although they are two separate companies, the fortunes of the global oil industry will impact them both at the same time.  Mr. Frank recommended an individual investor hold 30 stocks in at least 12 to 15 different industry groups in his or her portfolio.  An individual investor, when starting out, will not be able to immediately achieve this level of diversification, but can manage his or her portfolio over time to meet this level of stock diversity.

Mr. Frank also counseled that no individual stock in an investor's portfolio should exceed 5% of the portfolio's total value.  This rule is applied very easily to the investor's stock purchases when embarking on his or her investing career.  What this means is that the investor's initial goal would be to accumulate a minimum of 20 different stocks in almost as many different industries.  Once the investor's portfolio has been established, then the rule is applied with each subsequent purchase.  The 5% rule is really a simple way to maintain diversification.  If one stock grows in value to the point that it is overweighted in the portfolio, this is a sign that the investor should consider selling some of the position in order to regain portfolio balance.  He suggested the following:

Applying only to initial purchases, the 5 percent rule is waived in the case of appreciated stocks that are still significantly undervalued according to their fundamental corporate analysis.  I suggest you consider a 10 to 20 percent limit of any appreciated position in your portfolio.  The idea is to avoid the chance of being badly damaged if one or a few positions go sour, and if your "best stock" begins to represent more than 15 percent, a sharp (50 percent) drop in it would really set back the portfolio's overall performance.  Besides, you don't have to sell all or even most of the highly appreciated stock - just bring it down to 10 percent or less of the portfolio and reinvest the proceeds in other undervalued stocks, thus increasing stock diversification.

Mr. Frank also wrote about a second type of diversification in investing, i.e., time diversification.  We will investigate his concept in next week's blog.


The material from Al Frank's New Prudent Speculator by Al Frank, copyright 1995 by Al Frank, is used with permission of the copyright holders, the heirs of Al Frank.


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