Is Jim Cramer’s diversification advice insane?

Diversified Portfolio DMMDear Mr. Market:

Have you ever heard of a guy named Jim Cramer? If you’re a seasoned investor you certainly know of the television personality, best-selling author, and host of CNBC’s Mad Money show. If you’re a novice investor you may have heard of him as well due to his popularity but we would caution you to stay away. Why?

This article is not a hit piece on Jim Cramer. He is a wildly successful entertainer who adds color and talking points on the stock market but make no mistake about it…he is not your financial advisor. As a matter of fact he advises nobody professionally but by virtue of his massive media platform he commands a lot of attention, which gets construed as diligent financial advice or valid recommendations.

It’s actually because of Jim Cramer’s success that we want to bring him to your attention. His investing record is completely transparent and made available to the public. The subject of his performance (or lack thereof) is for another day, but what you should know is that ignoring someone that is successful is not smart but taking their opinion as truth is just as risky.

In one of Cramer’s most popular books, Jim Cramer’s Real Money: Sane Investing in an Insane World, he recommends that a beginning investor should start off with a five stock portfolio. Read the last part of that sentence again as it completely contradicts one of the other basic premises that 99% of even novice investors will inherently know; diversify your portfolio.

Is this “advice” from a guy selling books or is it commonplace in most portfolios? Since most advisors preach proper diversification there surely has to be some answer around how many stocks one should own in a portfolio, right?! Let’s just agree that it’s not five, or even 10 as he goes on to later suggest.

Even if we didn’t dig into the science and actual data behind how many stocks should be owned in a portfolio in order to be properly diversified, simple logic should prevail. In other words, owning 10 stocks in various sectors and industries is obviously more diversified than owning five. The overall consensus and general rule of thumb is that most investors should own 15-20 stocks. This of course assumes they want and can devote enough time to research and monitor them. Does this number seem right to you? Ironically, we think numbers like this are “insane” which counter the title of Cramer’s book!

The market has changed over the years and so has the science and data behind what it takes to be intelligently diversified. Forty years ago studies revealed that about 90% of the diversification benefit could be attained from owning about 16 stocks. In order to bump that up to 95% one would have to own about 30 stocks. More recently, however, research has shown that with the market environment we now have it would take at least 50 stocks to achieve those same diversification benefits.

If you’re still intrigued by owning individual stocks and believe you or your advisor can adequately manage 50 different companies, read on….because believe it or not, that amount is actually inadequate! The world and stock market is drastically different than it was in the 1960s. A 2002 study called “How Much Diversification is Enough?” found that the optimal level of diversification using rules of mean-variance portfolio theory, required at least 120 stocks.

Lastly, one of our favorite studies, which brings up the bigger message behind these findings, is by Eric Crittenden and Cole Wilcox. In their research and study of the Russell 3000, they discovered that the efforts and potential success of picking the right stocks is almost futile. From their study “The Capitalism Distribution” they shared the following results:

  • 64% of stocks underperformed the index
  • 39% of stocks were unprofitable
  • 25% of stocks were responsible for all of the market’s gains
  • 5% of stocks lost 75% of their entire value

Do you still want to spend your time trying to pick stocks or take “hot tips” from a guy on TV?

Hey…don’t get us wrong. Picking stocks can be fun (and certainly exciting) but it should only comprise a portion of your investing strategy. Your serious money deserves to be treated and diversified in a much better fashion…

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