How To Avoid The Mistake Most Investors Are Making

Brad Briggs's picture

Monday, November 17, 2014 - 9:00am

by Brad Briggs

It finally ended...

The Federal Reserve recently announced that it would end its third (and possibly final) round of quantitative easing (QE).

This brings to close the $1.7 trillion that was pumped into the economy in this round alone. October marked the last month of the $15 billion in monthly bond purchases -- down from $85 billion when QE3 started in 2012 -- and ends the nearly six-year bond purchasing program.

You can see what the program has done to the balance sheet of the Federal Reserve:

The central bank's bond purchasing program has sent the stock market soaring... and hopefully you've been able to capitalize on this tremendous bull market.

To put the recent bull market in perspective, we only need to look at the returns from what is considered the "lost decade" and compare that time frame when the Fed turned on the printing presses. The term "lost decade" stemmed from the sluggish performance of the Japanese economy after its real estate bubble burst in the 1980s and has also been used to describe the state of the U.S. economy from 2000 to 2009.

Our analysts have surely enjoyed this latest bull market. In fact, we've compiled a list of the top performing stocks from each of our newsletters. Take a look at how we (and hopefully you) have fared since the onset of QE:

When in the midst of a raging bull market like the one we are currently seeing, it's tough for investors to beat the market. In fact, even Warren Buffett himself hasn't beaten the market on a rolling five year basis. But we think that's about to change...

You see, it's tough to beat the market when A) the Fed has been pumping money into the market, causing a massive run in stocks and B) when you are the market -- meaning you are broadly diversified.

Now that the market will no longer be supported by the central bank's printing press, we should return to somewhat "normal" market conditions.

As for diversifying your portfolio, it's a great idea... if you only want to keep pace with the market.

We want to beat the market.

Most investors believe that diversification is the key to achieving market-beating returns.

"The more stocks you hold, the better right?"

Wrong.

Warren Buffett, arguably the most respected (and successful) investor in history, has been very clear about his views on diversification over the years.

Here's what he has to say about the matter:

-- "Wide diversification is only required when investors do not understand what they are doing"

-- "We try to avoid buying a little of this or that when we are only lukewarm about the business or its price. When we are convinced as to attractiveness, we believe in buying worthwhile amounts."

--"If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice. It's the 'LeBron James' analogy. If you have LeBron James on your team, don't take him out of the game just to make room for someone else."

So what gives?

Here's the dirty little secret that Wall Street is not telling you about diversification: as the number of holdings in a portfolio increases, the portfolio tends to act more like the broad market

You can see what I mean by looking at the chart below...

The chart above shows that as the number of holdings increases, the portfolio should provide the same level of risk as a broad market index.

And once an investor holds about 20 or more stocks, the portfolio's risk should be about the same as the market.

Think about it. The more stocks you hold, the more you ARE the market.

So if you are the market, why in the world should you expect to beat it?

Now, there are some exceptions. And I'm certainly not saying that the only way to outperform the market is by shouldering an absurd amount of risk.

But the bottom line is that if you're really looking to beat the market, you'll likely never do it with 20 or more holdings over a long time horizon. Instead, keep a tight portfolio that's focused on your best ideas.

That's exactly what my colleague Amy Calistri does in her newsletter, Stock of the Month. In fact, she never holds more than 12 stocks at any given time in her portfolio.

Her reasoning? By focusing on a select few stocks at any given time, she's able to do a much deeper dive into her best ideas than most analysts. And it's working... Stock of the Month has produced winning picks 84% of the time for 5 years straight. To hear more about her success, get her latest recommendation, go here.

Brad Briggs does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.