Happy New Year!

Best wishes for a healthy and safe holiday, and may all of your investments enjoy double-digit returns in 2006!

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Diversification: Is It The Key To Portfolio Management?

Although diversification has value as a prudent investment strategy, it also has limitations. Actually, it has only a few useful functions and it doesn't even begin to offer the amount of protection that many people think it does.

Simple logic tells us that the odds of acquiring a winning stock are better when more than one company is selected. It also suggests that safety is improved when investing in more than one company because the individual problems of one company probably won't affect the others in the portfolio.

Thus portfolio diversification can be properly defined as the placing of financial assets into significantly different investments, for the purposes of increasing the chances for larger profits, protecting against losses, and simplifying the analysis and selection process.

A practical diversification strategy that will protect all of the original capital is to buy U.S. Treasury bonds, and then use the interest from them for investing in the stock market. If the bonds are held to maturity, the principal is never at risk. Instead, it is returned as the bonds reach maturity.

Diversification is important as an investment strategy. However, while it can be used to lower the overall risk and increase the chances for better profits, it is also important to remember that risk is not eliminated with any form of diversification.

One should also pay close attention to the comments of Warren Buffett concerning diversification. According to Buffett: "Diversification is only useful to persons who really don't know what they are doing." And then Buffett also tells us: "Do put all of your eggs into only one basket, but then watch that basket very carefully!"

And finally, I would point out the three major flaws to diversification as explained by studying the Zurich Axioms:

1. Diversification forces you to violate the precept that you should always play for meaningful stakes.

2. By diversifying, you create a situation in which gains and losses are likely to cancel each other out, leaving you exactly where you began - at Point Zero.

3. By diversifying, you become (in effect) a juggler trying to keep too many balls in the air at the same time.

When you think about these three major flaws of diversification and weigh them against its single advantage - safety - it begins not to look so good!

And as for an answer to the question that started off this topic, I will leave it to the readers to furnish that for themselves.

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Take A Loss Quickly

Taking a loss is never pleasant and no one likes to do it. Yet, if one is to become an active investor, it will become necessary to take a loss from time to time.

If the decision has been made to sell and take the loss, it is risky to delay in hopes of getting a little extra. This usually results in an even greater loss as the price continues to drop even lower.

Once you have made a decision to sell and take a loss, you should complete the action as soon as possible. Why risk losing another 10 percent on the price? A market sell order will complete the sale with the greatest speed.

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Values Can Be Found By Bottom Fishing

Bottom fishing is a technique of using a limit buy order to purchase a stock that has been going through difficult times and has shown a significant price decline. The company might be currently out of favor, or the industry could be having its own recession. Cyclical stocks such as automobile companies, oils, heavy equipment, and to some extent food, all lend themselves to bottom fishing.

Bottom fishing can be highly speculative as there is no way to know just how low the price of a stock will fall. The strategy is most effective in an overall market decline, where value remains in individual companies. It can however be quite risky in individual stock situations - especially where stock price trends are moving counter to the stock market.

That the price will not find support after an investor buys it is the main risk a bottom fisher assumes. If the investor is correct, the strategy can bring great profits as the price recovers to former levels.

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Buy On Weakness, Sell On Strength

Buying on weakness - when a stock's price is declining - should only take place after it has been determined that the company in question is still fundamentally sound.

The price of a good stock in a relatively stable market will tend to move up in surges and then hesitate, sometimes even falling back slightly. It will often drift lower, looking for support from new buyers. When it finds support - the price where buyers enter the market - it will rise again.

Buying on weakness and selling on strength should be a matter of finesse rather than a total strategy. The finesse enables the investor to be more in control of the situation. It is taking action rather than reacting to a market situation, which separates the great investors from the mediocre kind.

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Follow A Few Stocks Well

If you have been following individual stocks for any length of time then you know that it can be either interesting and exciting or tedious and frustrating. It all depends on how you approach the task.

To become skilled at stock tracking one must have firsthand experience. You will learn more by owning a stock for two weeks than by watching a stock for two years. The reason is simple. Ownership places money at risk, and the risk of losing money greatly heightens one's attention.

Anyone who follows individual stocks should be aware of the fact that the price of a stock has essentially three main influences:

1. Direction and strength of the overall market.
2. The current investing theme - found in an industry group or sector.
3. Earnings. And here the trick is to trade on the anticipation of earnings rather than on the specific earnings increase. Once the earnings increase is announced, investors buying at that point are actually buying the stock at inflated prices.

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Good As Gold

Here is a low-risk play on the hot, highly volatile gold market. It's a five-year, FDIC insured certificate of deposit with the interest rate tied to gold bullion. Your earnings depend on the average price over the next five years. So if gold is $500 per ounce when you start, and the average is $600, the CD would pay off at 20%. But if the average falls below $500, you get your principal back. Minimum investment is $1,500.

These gold bullion certificates of deposit are available from EverBank, which you can find in our list of Links.

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Season's Greetings!

We'd like to take this opportunity to wish all of our members in the Christian community a Very Merry Christmas, as well as a Very Happy Hanukkah to our friends of the Jewish faith.

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Buy Low, Sell High

The idea of buy low and sell high is the basis of all business. The difference between the buy and sell transactions is profit. To make a profit is the reason why we buy and sell stocks. But while it is the one axiom most every investor understands, it is also the one that many have trouble implementing.

Cyclicals can be a good choice if an investor wants to buy low and sell high on the same stock. When they cycle down, buy. When they cycle up, sell. The only trick is to understand when the change is coming.

In using the simple buy low, sell high strategy, if the companies are carefully selected as fundamentally good companies, the rewards from stock ownership can be good and sometimes great. It may take some time and patience for the stock to perform well, but it is often worth the wait.

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Some Thoughts About Price Averaging

Price averaging can be a very prudent strategy - but only with the right stock or situation of course. Price averaging is useful for lowering the average cost of a stock purchase, and there are two ways of doing that. One is by averaging up, while the other is by averaging down.

Averaging down is often not the best course of action because it is impossible to know where the price decline will stop. Also, it takes discipline to keep buying more stock at regular intervals as the price continues to drop.

Averaging up may be less risky than averaging down. When an investor's stock price suddenly takes a turn for the worse and the price declines significantly due to bad news, the investor holds the position because he/she knows the company and believes the price decline to be a temporary situation. Eventually the stock price will reach a support level, and the investor plans to average up as the price recovers.

Averaging up enables an investor to make a move based only on the price recovery of the stock. It is more comfortable to add money to a stock position when the price is rising instead of declining.

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Sell The Losers And Let Your Winners Run!

This is one of the oldest sayings in the arena of stock market investing and it always makes abundantly good sense!

It's a prudent thing to do for any investor - to sell any stocks that are losing money. But just what constitutes a loser?...Is it when the price of a stock drops from its high?... Or is it when the current price of a stock you hold is below its purchase price?

You should be able to agree to the fact that any price drop is a losing situation because price drops cost an investor money.

The cause of any price correction determines whether a stock is still a winner. Is it caused by a weakness in the overall market?... Or daily fluctuations of the stock price?... Or long-term complications such as declining sales, tax difficulties, or legal problems?

Winners are the stocks of those companies showing consistent growth in sales revenues, earnings, and price. They are the leaders in their industry and have continued new product developments for new or existing markets.

Winners should be held until the fundamentals that make them winners begin to weaken, or until the price runs too far ahead of the earnings, causing a decline in value.

Stocks trade on the anticipation of future growth. At times, the anticipation vastly outpaces the growth and even the growth potential. Add the news of weaker earnings to that anticipation and the stock price gets hammered down hard.

Losers are taking money from the investor and should be sold and forgotten until such time as they stabilize and rebuild the fundamental strength necessary to be winners once again.

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Opportunity Investment - The New Way To Get Rich Rapidly

This new way is catching on all-around the world. People are compounding money rapidly for themselves. It's called "Opportunity Investment," and it has nothing whatever to do with the traditional ways of investing such as stocks, bonds or mutual fund shares.

This is hands on. And the entire premise is based on compounding, and becoming the "investor source."

It's a fact: Whenever we hand over our funds to the so-called "professionals" to do the investing for us, we actually dilute our returns dramatically. It makes sense if you really think about it. The real reason? Because the so-called professional money managers have neither the interest nor incentive to manufacture returns any better than perhaps 10% - if you're lucky!

"Opportunity Investment" is a term that describes the process of taking responsibility for your own funds, and thereby becoming your own "investor source."
What this means is that you determine by your own daily actions and decisions what your returns will be.

There is a book written to better explain the process: "The Inside Trade Secrets to an Ethical Opportunity Investor" - by author Hayden Muller.

The idea is to identify "investment objects" that are endowed with "excess intrinsic value." Then by recognizing profit where others do not, we thus place ourselves into position to access this unseen stored portable value, and transform it into profits which we then can pyramid and compound into a rapid fortune.

The process is really not new; it has been the pathway that all high net worth individuals have used for hundreds of years. What is new, however, is the way that it is packaged as a book and disclosed freely to all who choose to recognize its worth.

You can learn more about this by visiting the Opportunity Investor Website which you can find in our "Links" listing.

NOTE: This is not an endorsement for the book, but merely a means to inform you about an interesting approach to investing that merits further investigation. As always, caveat emptor!

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Looking Back At 2005

This has been a rather somber year for persons who have been invested in the so-called "traditional" investments like stocks, bonds, and mutual funds.

While it is true that stocks and bonds are both up a small fraction for the year, they simply are not the places where money was being made in 2005.

Here is a look at the year-to-date gains for a variety of investments:

Corporate Bonds: +1%
Junk Bonds: +1%
Stocks: +2%
Treasury Bonds: +2%
REITs: +3%
Mint Gold Coins: +10%
Gold: +11%
U.S. Dollar vs. Euro: +14%

What the future holds in store is anybody's guess, but the stock market at this time is nothing to get overly excited about. In fact, there is reason to be concerned about stocks based on a recent news report in which the Treasury Department reported that foreign investors purchased $25 billion worth of U.S. stocks in September, 2005. This is the largest number since February, 2000.

The last time foreigners bought U.S. stocks at that rate, the Nasdaq dropped over 50% just one year later. That is not a good sign for stocks now.

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Taxing Matters

This is the point of time when, if you have paper losses on any of your stocks, you should be certain to take those losses before year-end. And the point here is to try to wind up 2005 with at least $3,000 in net capital losses because that is the most that can be deducted against your ordinary income during any calendar year.

If you are fortunate enough to have realized net capital gains of $20,000 for the year so far, and if you are at the 15% tax rate, then you would owe Uncle Sam $3,000 on those gains.

One way to offset that tax however, would be to take at least $23,000 worth of losses by year-end so you would end up with a $3,000 net loss.

Don't worry if you should have more than enough losses in order to get your $3,000 deduction because any excess losses can be carried forward and used to offset future gains.

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Do You Have An Investment Strategy?

Each of us has special needs and objectives we want to accomplish. And when it comes to building a secure future, we need to look at our investments as the vehicle that will get us to our goals. Every investor has the capability to use their knowledge and expertise to develop an investment strategy that will protect them well into the future.

Your eventual goals as an investor should really be fourfold: Cash flow, income, appreciation and financial security. However, while many of us are at different levels in our quest to reach these goals, each of us realizes that we must do something now in order to secure a financial future for ourselves and our families. After all, isn't that why we became investors in the first place?

To help you develop an investment strategy - in case you haven't already done so - here are seven (7) questions you need to answer for yourself as to what your investment strategy should be. In doing so, be sure to take into consideration both your family needs as well as your outside interests as you answer these questions.


1. What is your present financial situation? Are you gainfully employed? An entrepreneur or a retiree? And does your present income cover all of your expenses? It is most important that you answer these questions with total honesty.


2. What are the financial goals/obligations you must meet before you retire? Are you taking care of an elderly parent? Do you have children that you plan to put through college? Are you helping to support a married child with a family? These are real situations that just won't go away so you need to allow for them. After all, this may be how you are spending your money at the moment, so where does that leave you in terms of planning for the wealth accumulation you will need to fund your retirement?


3. How much investment capital do you need if you are just starting an investment program or, how much do you need to keep your existing investment program going?


4. How many years are left until you intend to live off your retirement income? It is very important to be realistic in answering this question.


5. What annual income will you need in order to retire comfortably? A good estimate is to figure 70% of your current income.


6. How many years do you expect this income to last? This is not an easy question to answer. Perhaps you can use your family history as a guide.


7. How much investment risk are you willing to take today, to accomplish your goals in the future? This is one of the most important questions that you need to answer for yourself because many of us are really not risk takers. Many people leave money sitting in a bank savings account or in a money market fund because they are afraid they will lose it. So the answer to this question will determine just what risk you are willing to take in order to achieve your goals.


So what exactly is your ticket to retirement? Any expertise that you acquire through your investing activities can be used to compound your wealth. And one of the best vehicles for doing that is to have a self-directed retirement plan where the plan administrator or custodian allows you, the IRA owner, to acquire the kinds of investments in that plan with which you have had the most success as an investor. And this can mean moving beyond stocks and bonds or mutual funds to include things like rental properties, timberland, or even businesses for example.

To learn more about this subject, you can go to "IRA-PLUS" in our Links listing.

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How To Measure The Risk In Your Portfolio

How can you figure out how much downside risk an investment exposes you to? Answering this critical question can be tricky. There are so many ways to calculate risk. On top of that, many risk measures have their own limitations. And then there's the separate question of how you should use the risk barometers you pick. But there is one rule you should always follow. Although it is easy to get a separate risk reading on each of your investments, you should care only about how your portfolio rates as a whole.

It's important to go for the big picture because a diversified portfolio carries less risk than the sum of its parts. The reason is that in a diversified portfolio, individual components - such as stocks and bonds - are unlikely to move in sync, especially over the long term. Thus, each can offset some of the other's risk. The volatility of stocks, for instance, could be balanced out by the fixed interest and principal payments of bonds.

It's hard to grab a calculator and arrive at a figure that reflects the overall risk in a portfolio. Still, a back-of-the-envelope reckoning provides a rough, though inflated gauge. Just research the risk scores on each investment and multiply by their percentage weightings in your portfolio. Then calculate an average. It's not ideal, because it fails to account for diversification's risk-reducing magic. (It goes without saying that if you are diversified then your risk is probably going to be less!)

For something more accurate, you can use a free Web service such as Financialengines.com to assess how risky your portfolio is, compared with that of the average investor. To define risk, Financialengines uses the measure known as standard deviation, which it expresses as a numerical score. For instance, if the rating on your portfolio is 1.4, then you are taking 40% more risk than the average of 1.0.

Whatever approach you take, the results will be easier to interpret if you have a grasp of how professionals measure financial risk. When it comes to stocks, investors confront two types of risk. One is posed by market downdrafts, which can punish even the most worthy investments. The other consists of problems specific to companies, such as mismanagement or obsolete products. For mutual funds, there is a third variety of risk, which is posed by a bad manager who charges high fees and doesn't make enough to recoup that cost.

Happily, about 96% of company-specific risk can be eliminated simply by owning a diversified portfolio of 40 to 50 stocks. The risk that remains - a loss due to a market sell-off - is captured in a measure called beta. Beta compares the magnitude of an investment's price-swings with the market's overall fluctuations.

Appealing, because of its simplicity, beta is sometimes too crude to be useful. For one thing, it is often calculated compared to the S&P 500, a large-cap measure that is a poor yardstick for other asset classes. To find out whether you can trust beta to give you an accurate picture of an investment's risk, look up another statistical measure, R-squared. This tells you the degree to which an investment's price rises and falls at the same time as the benchmark it is being compared to. An investment's beta can be considered reliable only if its R-squared falls between 85 and 100, meaning that it closely tracks the index.

When confronted with a low R-squared, find a beta based on a better benchmark. For mutual funds, Morningstar.com publishes betas that use both the S&P and the most appropriate index. For stocks, Personalwealth.com tailors betas to peer groups, such as computer hardware stocks. But be wary of beta when a company or fund specializes in fast-changing technologies. In such instances the beta is going to change rapidly. Of course, if your holdings are not diversified, it can be dangerous to rely on beta at all, because when it comes to individual stocks, beta explains only 35% of the risk. The rest is due to company-specific developments.

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NEXT MEETING: Thursday - December 15, 2005

For our final meeting of 2005, we'll touch briefly on asset allocation and related topics like diversification and portfolio rebalancing. Then we'll talk about our plans for 2006 and welcome any suggestions you may have on that subject. And finally since this is the Holiday Season of gift-giving, we're going to try something new that I'll fill all of you in on at this meeting.

NOTE: As we are now entering the winter season when adverse weather conditions can materialize rather suddenly, please make it a point to check this Blog on the date of our scheduled meeting (December 15th) to learn if there is any change to our meeting. We do not anticipate any unusual weather conditions, but forewarned is forearmed as the expression goes.

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We meet monthly on the third Thursday of the month at DePaul University, located at 150 West Warrenville Road in Naperville, Illinois. The meeting starts at 7:00 PM and ends at 9:00 PM. The room number for this meeting will be posted on the easel that stands near the reception desk in the main lobby.

We have an annual membership fee of $15.00 which covers our twelve (12) monthly meetings. Non-members are invited for a donation of $5.00 per meeting.
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