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Originally Posted by ea1776
Thanks for the post. I would argue that you *can* stay diversified with only 5 stocks and a 25% cash position. This means any one stock has <= 15% of your 401(k) capital at any given time.
I define diversification as spreading out your capital among solid investments across several *sectors*. For example, I would rather own 2 of the most quality stocks in the S&P 500 in 2 totally different sectors (tech/pharmaceutical), than an equal share of the entire S&P500 (index fund).
Your point is well taken though. With this style of investing, you would definitely want to choose investments very carefully, and do a good amount of research while you own them as well. I also believe I can afford greater risk due to my age.
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What you are talking about is a known technique managed funds use all the time- overweighting strong sectors. What you need to realize is this:
a) if one stock in sector has bad news, it tends to take the whole sector with it. Enron took down energy, worldcom took down tech and telecommunications.
b) the DOW is diversified with 30 stocks. Some others have researched that having around 15 stocks is more than enough, and owning more than 16 stocks does little to improve return or reduce volatility. Yet when you look at S&P 500 index, it is considered quite volatile.
c) a common investing technique is making large bets on minimal positions. Janus 20 and many other mutual funds do the same thing (is Janus 20 even around anymore?).
IMO the goal of investing is the best risk adjusted returns. If two investments have an 8% return, the one with the least risks is the best investment. If two investments have a 4% return, the one with the least amount of risks is the better investment.
If you are looking at stock investing, my advice is learn more about small caps and IPOs. That is where the real high returns are. Placing bets on Microsoft, Dell, Oracle, GE or P&G will get you market returns, maybe plus or minus a percentage. Hardly worth the risks. You might get the 8% return of the market, maybe 9-10% return. But you could get that same return with less risk in a mutual fund investing in the whole large cap index or a managed large cap fund.
Small caps on the other hand have huge possible returns. I read that the bull market of the 90's was due to 5-10 companies growing at 100X market cap. Out of nowhere Cisco, Intel, Microsoft, Dell, Oracle and a few other small companies rose up and created the bull- which then lifted the profits of the companies around them (tell me a company which does not use a product from 4 of those 5 companies).
As I invest in stocks, I usually look for small or mid caps to buy small positions in now, then hold them for years and years in a taxable account. Because as the company grows, my small position will become quite large.
With mutual funds I look to double- get a 2 bagger- every 5-7 years.
With stocks, Peter Lynch always commented to look for the 10 bagger- look for the stock you can hold and hold and get a 10X return on or 100X return on.