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Friday, June 19, 2009

Stock Market Diversification

In one of my previous articles (Investing in the stock market -9 powerful tips), tip number one was:

1. Do not spread your money too thin.

My friend has a little over $200,000 invested in the stock market through 27 different Mutual funds. In my opinion, 27 Mutual funds is 27 too many collecting load fees, management fees, commission fees, operating and advertising fees. Diversity is important, but just as important is over-diversification. Also, in my opinion, $200,000 should not be put into more than 12 stocks, let alone 27 different Mutual funds.

If I may, I would like to explain where I’m coming from by stating that tip.

On October 16, 1990 the Royal Swedish Academy of Sciences awarded 3 men each a third of the Nobel Peace Prize for their work in the theory of financial economics – Harry Markowitz, Merton Miller and William Sharpe.

Harry Markowitz’s work involved the theory of portfolio choice. (This in layman’s terms was the introduction of a diversified portfolio to help offset the uncertainty and risk of investing in the stock market. Harry Markowitz has been labeled the ‘Father of Diversification’.

William Sharpe used Markowitz’s model from an individual investment theory to a market analysis theory based on price formation for financial assets. This formulation is called Capital Asset Pricing Model (CAPM). From what I understand about this model is that it places a “beta value” on a share, the higher the beta value, the higher the risk. By knowing the ‘beta value’ of each stock in a portfolio, the portfolio can be adjusted to either involve more or less risk.

Merton Miller’s work involved dividends supplied by companies to a shareholder and its effect on stock market value and the effects of taxes. Miller’s theorems are used for theoretical and empirical analysis in corporate finance.

Markowitz received his award for an essay published in 1952, “Portfolio Selection” and for his book in 1959, Portfolio Selection: Efficient Diversification.

Harry Markowitz, in his Nobel lecture given in 1990 says: “an investor who knew the future returns of a security with certainty would invest in only one security, namely the one with the highest future return’.

Nowhere could I find that an investor should own 27 different mutual funds.

For more excerpts from the book ‘The Stockopoly Plan’ please visit http://www.thestockopolyplan.com



By : Charles M. O’Melia
Charles M. O’Melia is an individual investor with almost 40 years of experience and passion for the stock market. The author of the book ‘The Stockopoly Plan – Investing for Retirement’; published by American-Book Publishing. To order a copy of the book: http://www.pdbookstore.com/comfiles/pages/CharlesMOMelia.shtml

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