Arbee started yet another round of debate on diversification. It's always interesting to see people come up with all sorts of arguments to support their methods of investing; diversify or otherwise. Well, obviously if you have decided to go with a particular method you are already decided. No one can change your mind about it. You can argue till your tongues fall out neither will convince each other to change. I think D-Man says it best "Did you say diversify? Well why didn't you say so? Maybe if you repeat it 10 more times..."

Nevertheless, I still want to share my views with everyone. But take them with a grain of salt. And, no, you don't have to agree with my views. Soak them up or spit them out as you wish.

Before I get to my simple formula to decide whether diversification is for you, there are some myths I want to bust about investing:

1. Paying for professional investment advice is worth it.

My rule for paying for professional investment advice is simple: I will pay only if I make money. For this reason, I stay away from mutual funds and any other funds that charge a fee with no guarantee of market-beating results. It's really kinda stupid to pay these guys money when they don't guarantee anything in return. Indulge me if you will.

Imagine you are playing the three card monte (which by the way is really a con) for $10 per bet. A bystander (let's call him John) approaches you offering to point out where the King of Hearts is for a fee of $2. But John makes no guarantees that his picks are accurate. John's only credibility? He's been doing this for years, full time as a professional three card monte advisor. To be absolutely clear, John is not a shill for the card dealer. So clearly, John has no idea where the King of Hearts is. Although John's been advising for years, his picks are only as good as yours. Why? Because he's a professional advisor, not the card dealer. Only the card dealer knows where the King of Hearts is. Sure after following the dealer for a while, John may pick up a few signals from the dealer. But the dealer may change his signal every now and then. But how can John call himself a professional advisor? Because it is his job to sell his advice, and over the years he has become an expert in selling his advice, not in picking the right card.

If you are still with me, you will realize John is like the mutual funds or professional investment advisor. The dealer is like the market. So now, ask yourself "Will you pay for John's advice?" Don't get me wrong. I'm not entirely against professionally managed funds, only funds that charge fees regardless of the outcome (which means almost all the funds). The only funds I will invest in are funds that charge a fee only if you earn market-beating returns. I don't know if there's any out there (at least not in the US). But Buffett did this a long time ago with his Buffett Partnerships Ltd where he charged 25% of profits above 4%. Jim Chuong has setup his Chuong Investment Partnership much like Buffett's. He charges a 33.3% fee on profits above 2%. I think the fees are high, but it's a start. Unfortunately, the partnership is limited to Canadian citizens only. And only 35 seats are available. If you are Canadian and decided to invest in his partnership after reading this, let him know I sent you. May be he can somehow give me a share of the partnership or cash. ;)

2. Only a handful of professionals can beat the market. Amateurs don't stand a chance.

I dropped a hint in myth #1 that professionals are not necessarily good at picking the best investments, but they are great at selling their advices. Of course there are exceptions. Some professionals consistently do well. To prove my point, I'm not going to reiterate a popular argument for the amateurs here: Amateurs are not limited to any securities. Oops, I guess I just did. Anyway, I'll illustrate with the help of Jim Chuong, yet again.

Let's dig a little dipper about this Jim Chuong character. Who is he? How did he get to the point of managing money for other people? Ok, pop quiz: Those of you who think Jim Chuong has a degree in finance, raise your hands. 1, 2, 3, ... Yeah, pretty much all of you.

The good news is those who raised your hands are partially right. He has a degree in materials engineering from U of Toronto, not in finance. With a materials engineering degree, you would think he would work in some engineering firm. But no, he started a company with a friend that offered Internet programming services. This, my fellow readers, is a telltale sign of a success in the making.

One who has the passion to succeed, can and will succeed in ANY field if one works really hard and believes.

- FatBoy

I mean, here's a guy who graduated with a material engineering degree in 1997, became a computer programmer in 1998 and started his investment partnership in the same year. When you compare yourself to his successes, it's pretty humbling, isn't it?

Anyway, back to my point. Jim Chuong is a self-taught investor with no formal training in finance. His "mentors", if you will, are books such as Peter Lynch's One Up On Wall Street and Benjamin Graham's The Intelligent Investor (both my personal favorites, funny how different he and I turned out to be). His investment partnership earned an average annual return of 22.9% since inception in 1998.

Of course, the skeptics will now argue that Jim is a professional even without formal financial training because, duh, he manages a portfolio. That's the biggest pile of horseshit. If he made the same average annual return without starting the investment partnership, will you consider him a professional? Uh huh, that's what I thought.

3. Focused investing cannot outperform the market.

I promise you this is the final myth. I know this is getting a little too long. But bear with me. I'm going to reuse Jim Chuong as my example.

Guess how many stocks he owns? 12? 20? 50? 100? The whole market? Wrong, wrong, wrong, wrong and wrong. The answer is 5, two of which he owned since 1998. Chuong's managed portfolio earned a 278% return while the S & P 500 returned 25% over the same period. Gee, focusing on a few stocks sounds pretty good right now, huh?

"But Chuong's a genius!", you scream in frustration, "I don't have the genes." Hey, if you say so. The world needs people like you and people like Chuong. People like you, who blame your genes for every failure, makes people like Chuong look like geniuses with genes somehow inherited from Albert Einstein. Time for another FatBoy gem of widsom:

You have failed if you didn't even try.

- FatBoy

The truth is investing in index funds cannot outperform the market because you are buying the market. The only way to outperform the market is to pick the good lemons out of a basket of rotten lemons. If a market return is good enough for you, then buy the whole basket. If you want a market-beating return, you have to try to pick the good lemons or pay someone to pick for you (remember myth #1). There's nothing wrong with going for market returns. Everyone has their own thresholds for risk. Going for the market return obviously has a lower risk than going for a market-beating return.

And now, FatBoy's formula for deciding whether you need to diversify:

The more risk averse you are, the more diversification you need.

- FatBoy

Conclusion
So, diversification is just a tool like every other tool in life. It works for some jobs and not for others. Pick the proper tools to accomplish your goals. In the end, all that matters is you made money and you are still alive to enjoy it. Nobody cares if you diversified or not to reach your million-dollar mark. If you are a millionaire, you are a millionaire. No one dares to say you are stupid because you didn't diversify or otherwise. If they do, start throwing pennies at them until their lips bruise black and blue.

A final note about Jim Chuong: He was featured in multiple magazines and a TV show. You can read more about him by following the links to the interviews at the bottom of his Chuong Investment Partnership page.

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