Virtues of Diversification

By on November 13, 2006

Originally published in January 2001:

INDEXES ON 12/29/00

DJIA 10,786.85

S&P 500 1,320.28

NASDAQ 2,470.52

Editorial

It was an incredible year marked by a crash in what was the darling in investor’s hearts; the technology sector. We have experienced rolling sector corrections over the past few years. The market got rolled by a correction which hit what has become the biggest sector in the economy. The consequences were devastating. The average growth fund was absolutely pummeled in the year 2000. The NASDAQ cratered by a monumental 39%, which will go down as its worst year ever. Very few investors sidestepped the carnage. Most investors overweighted growth funds after the incredible returns achieved in 1999. It was hard for investors to pass up funds bragging of returns greater than 100% in 1999. In the end, performance chasers got walloped as usual.

Amazingly, despite the tech crash, it is hard to argue that there are a lot of bargains in this area. Price/earnings ratios remain unusually high for a sector with slowing earnings growth. The internet is nowhere near dead, but most of the participants on the fulfillment side have been mortally wounded. The market was very irrational and inefficient in the pricing of these securities and a lot of investors suffered in the process of return to equilibrium.

The year 2000 provided a powerful lesson on the virtues of diversification. Investors who stuck with the average small and mid-cap stock didn’t have a terrible year. By avoiding over-concentration in the most popular sector the “real world” aggressive portfolio at this site gained 12% for the year, beating the S&P 500 by an abnormal 20 percentage points. This was a huge relative turnaround from the sub-par return of 17% by that same portfolio in 1999, which trailed the S&P 500 by a sobering 6 percentage points. The aggressive portfolio is now significantly ahead of the S&P 500 over the past 5 years.

The economy should start picking up after it hits bottom in approximately 3 months. Long-term interest rates have been declining and short-term rates will be soon. Demographics are still a big positive for the economy and the stock market and will continue to be for the next 6 to 7 years. This should limit the drop in the S&P 500 to around 20% from the top, which would put the absolute bottom around 1200.

What will be the one of the best areas for investment over the next 10 to 15 years? I believe that investors should overweight the health care sector. One of the reasons for this is that assets of American consumers are being confiscated by the medical establishment. To keep up with the wild inflation in medical costs American workers have resorted to working longer hours, taking two jobs and having two working heads of the household. This has resulted in increased stress, which begets stress-induced illnesses leading to more transfers to the medical establishments, ad infinitum. This is an unfortunate situation, but that shouldn’t prevent us from capitalizing on it. When you add the demographic profile of this country to the equation you get a very powerful fundamental boost to this necessary sector. If you want to make money in the next decade, buy stocks in companies that can profit from this non-virtuous circle. One of the better funds specializing in this area is the Vanguard Health Care Fund.

Portfolio Note:

Due to International Game Technology (NYSE: IGT; 48) becoming more than 10% of the aggressive portfolio, ½ the position will be sold. Clayton Homes (NYSE: CMH; 11 ½) will be purchased with the proceeds. CMH is one of the stronger companies in the manufactured home industry, which has suffered through a severe downturn the past 2 years. Much of the competition is on the death watch, so CMH should see increased market share after the excess inventories are worked off.

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