June 19th, 2008

Cramer’s "Are You Diversified?"

I can’t help but comment on the above named Mad Money segment. I understand that Cramer needs to fill an hour nightly and that he is limited in his fast paced show to sound bites but ….

He introduced the segment last night by telling his gullible audience about the various predictions calling for a major bear market decline in the next several months. I wrote about that myself on June 17. It’s not so much that Cramer endorsed the notion that the market might decline, rather he said that the average individual investor needed worry if they had a “well diversified portfolio”.

Sorry, I couldn’t disagree with him more. Let’s assume the following hypotheticals:

  • You’ve did a great job of diversifying your portfolio on October 15, 2007, just like Jim told you to do, and bought 30 stocks in a diversified list of industries; basically, you bought the 30 stocks in the Dow Jones Industrial Average.
  • Or, to really cover your all your bases, you put all your money into an index fund or purchased SPY etf’s thereby, theoretically, having some money in each of 500 stocks in all the industry groups comprising our economy.
  • The market declined by 18% from 1565 on October 9, 2007 to 1276.60 on March 17, 2008, or 18%.
  • Or over the next 6-12 months, the market declines further to 1150, or another 15%. (That’s the level I first mentioned in this blog on March 1; I stand by that unless and until the MTI confirms the end of this correction by crossing back over the 180- and 300-day moving averages).

If I had diversified as outlined above, Jim couldn’t have push the buzzer and said I wasn’t diversified, could he? But how would that “diversified” portfolio actually perform. By definition, it would have decline the same 18% between October and March and will, should the market decline to 1150 on the S&P 500, cost me another 15%. Rather than protecting my assets, diversification merely prevented me from performing worse than the market.

So Jim could argue he didn’t mean that sort of “diversification”. He didn’t mean diversification into more stocks but, rather, stocks in several different, select industries. But that begs the question of “which industries”?

Some time back, Jim instructed that the stock market predictably cycles through various industries as the economy goes through a typical economic cycle. At the time, he instructed that the first industries who’s stocks turn up as the economy moves out of recession are the financial and said that when financial stocks started moving up the rest of the market would follow. (Personally, I think it will be quite some time before financials will be heading appreciably higher given all the damage that needs to be repaired.) The table below, courtesy of Fidelity Investments, overlays the various S&P 500 Industry Sectors on top of a typical economic cycle:

So it’s not really diversification that matters, it’s being in the right industry groups. You could have made lots of money since October, 2007 had you put all your money only into energy, coal, rail, farming and fertilizer stocks …. but you wouldn’t have been truly diversified according to Jim.

But if you were afraid to select industry groups or individual stocks, the best “diversification” Jim could have suggested was to “time the market” and pull out of stocks and leave your money in cash. But he didn’t.

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