Diversification is over-rated, and at times diversification is stupid

by JDH on April 2, 2011

It has been a very busy week, so without further ado, let’s get started. First, as you know I generally only post my detailed thoughts once a week, every Saturday, usually around 8:00 am Eastern time. This week I had more to say, so I posted three times during the week.

On Wednesday I posted on RIM – Research in Motion – Why I Bought It. I won’t re-hash it here; you can read it for yourself. Then on Thursday I posted that Dines Sells Pinetree – That’s Amazing! Again, I won’t repeat myself here; if you are interested in The Dines Letter or PNP.TO – Pinetree Capital Ltd. you can follow the link and read it for yourself.

Also this week I posted a new page called Silver – Why It’s Better Than Gold. (It isn’t really “better”, but it is different, so take a minute to scan the article. I’ll wait).

Now that you are back, here’s my main point today:

Diversification is often over-rated, and at times diversification is stupid.

Allow me to explain.

I am of the view that silver (and gold) are in a long term bull market, for many of the reasons I referenced in the above noted ed Silver – Why It’s Better Than Gold article. If that’s true, it’s likely that the price of silver will continue to increase for many more months, and perhaps years, to come. Yes, it’s highly volatile, but I think we all believe that in the short, medium and long term, then trend for precious metals is up.

If that’s the case, would it not be logical to over-weight your portfolio in silver? Why bother buying other stuff if you believe that silver will go up by more than anything else?

A financial planner will tell you that diversification is important, because if one sector does poorly, and another one does well, at least you reap the gains from the one that did well. If you put all of your money in the weak sector, you can lose big. They would tell you to invest in “opposite” industries, so you are protected from volatility. By “opposite” I mean counter-cyclical, so you invest, for example, in luxury consumer goods (that do well when times are good), and consumer staples that perhaps do better during a recession.

That makes sense, but diversification also means you will only, at best, get average returns. Your winners will be counter-balanced by losers, so you will never hit a home run.

So, in honor of the start of the baseball season, I will offer an alternate view point: just hit home runs.

If you are confident that silver (or anything else) will do well over the next few months or years, then put most of your money in it. If you are totally completely wrong you will lose big, but if you are right, or close to right, you will win big.

In the last twelve months SLW.TO – Silver Wheaton Corp. is up 153%. Obviously the correct choice a year ago was to put all of your money in Silver Wheaton. Most other investments didn’t do nearly as well. (The S&P 500 was up 13%, which is still pretty good).

Am I suggesting picking one stock and putting everything in that one stock? No, because picking the one perfect stock would be close to impossible. If the president of Silver Wheaton resigns and that hurts the stock, I’m in big trouble, even though I was correct about the trend for silver.

What I am proposing is to diversify within the sector, while still loading up on the sector I want to own. So, to that end, this week I began buying, or increased my positions, in the following silver related companies:

In the blue chip, low volatility category:

PHS.U.TO – Sprott Physical Silver Trust As the name implies, this is a trust started by gold and silver guru Eric Sprott that holds a bunch of silver bars representing 22,298,540 ounces of silver, worth around $840 million. All bars are stored at the Royal Canadian Mint in Ottawa, Canada, and you go on the Sprott Physical Silver Trust website and see a list of all bars. That’s good, because most other ETFs loan out their gold and silver, so you don’t know what is actually there. With this one, it’s there, so you know what you are buying. Approximate portfolio allocation – 20%

CEF.A.TO – Central Fund of Canada Ltd. – This fund holds, by dollar value, approximately 45% silver and 55% gold, so it has great exposure to both metals. The Central Fund website has more information, including net asset values. At the moment the premium is only 5.4% over NAV, which is very low, so it’s a good time to buy. Approximate portfolio allocation – 15%

In the blue chip, higher volatility category (with hopefully the potential for greater gains):

SLW.TO – Silver Wheaton Corp. is the mother of all silver stocks. They have royalty streams from multiple sources, so it’s already a diversification play. It’s my biggest blue chipper winner of the last year, and I have no plans to sell. Approximate portfolio allocation – 10%

SSO.TO – Silver Standard Resources, Inc. – I have stink bids in, but no purchases this week. Approximate portfolio allocation – I haven’t decided yet, but probably no more than 5%.

Of course you want some higher risk, higher reward juniors; here they are:

SVM.TO – Silvercorp Metals Inc. – A junior producer, with lots of upside (and potential volatility, so again, stink bids are the way to play it). I’ve owned it for a while, and I’m up over 100% on it, so I have no further purchases planned, but I am holding. Approximate portfolio allocation – 3% (But it’s currently around 8% of my portfolio due to recent gains, so I’m still debating about whether or not to lighten up).

SMD.V – Strategic Metals Ltd. – I did well of this stock in the past, and I’ve got stink bids in on it now; I’d like to start buying around the $2.80 level. Approximate portfolio allocation – 2%

FR.TO – First Majestic Silver Corp. junior with potential;
Approximate portfolio allocation – 2%

FVI.V – Fortuna Silver Mines Inc. junior with potential. Approximate portfolio allocation – 1%

I’ve got a few others on the list, but you get the idea.

As you can see my plan is the heavily weight the less volatile blue chips, and then place my bets on smaller ones for increased potential return.

That’s the plan; we’ll see if I’m correct, or if I get to play the part of the April Fool.

End of the First Quarter of 2011

Now that the first quarter of 2011 is history, how did we all do in our 2011 Predictions, which you will recall, I invited you to submit at the end of 2010? The winner of the first quarter “guess the price of Gold” award goes to Peter518, who was closest with his prediction of $1,450. The actual closing price of gold on March 31, 2011 was $1,431.90, so that’s a quite close.

For the record, I predicted $1,500, so I was somewhat optimistic (as I usually am). The average for the group was $1,463, so the group was also optimistic, but not that far off.

In the “guess the closing price of the DOW” category, the winner was JohnB, with a prediction of 12,500. The actual closing price of the Dow was 12,319.73, so that’s also very close. Honorable Mention goes to both Peter518 and yours truly, JDH, with our prediction of 12,000. The group average prediction was 12,333, so as is often the case the group was once again eerily accurate.

That’s my report for the week. Thanks for reading; feel free to post your thoughts on the Buy High Sell Higher Forum, and see you next week.

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