Ask Colin

If you have a broad portfolio of stocks isn't the idea that some go down, but are balanced by others that go up, so overall you get the general growth in the economy and therefore a mediocre result?

Having a long term diversified portfolio that is not actively traded has the advantage that the failure or very poor performance of one or a few companies will not cripple your results. This is the basic idea of diversification - to lessen specific risk. Specific risk is the risk associated with any one company failing or doing really badly.

A broadly diversified portfolio of stocks will tend to perform about the same as the market index - the mediocre result against which we assess professional fund managers. If this is the return that is sought, then it makes sense to invest in low fee index funds, which will do that job very effectively.

However, most people who manage their own funds do so for two reasons:

1. To avoid big fees.

2. Because they think they can do better than the professional managers.

Avoiding big fees can be done through index funds, as I just said, but to beat the professional managers means that you have to adopt a strategy that is different to theirs. Running your own broadly diversified portfolio will not achieve it - only avoid the fees.

The scope to out-perform the professional managers comes down I think to three possible strategies:

1. Time the market. Be out when it is going down, but in when it is going up. Theoretically this will give a better result that being in the market all the time. However, it is not easy to do.

2. Pick the stocks in your portfolio and manage the portfolio better than the professional managers. Again, this is not easy to do.

3. Focus your portfolio on a smaller number of stocks and on smaller companies that are not used by professional managers. This obviously increases risk - less diversification and higher volatility of results. Again it is not easy to do.

In fact, the best approach might be to try to use all of these three strategies.

The problem is that most people who set out to manage their own money in the stock market overestimate their chances of success and the time it will take to learn. Indeed, I think that most of them fail to beat the professionals - even after big fees.

However, I think it is possible to learn how to do it providing one is prepared to do lots of hard work, read/study widely and have the aptitude for investing.

What I advocate is that people wanting to manage their own money in the stock market put between 80 and 90% of their funds with a diversified range of managers with good long term records or in index funds. The more money they have the bigger the proportion that should be given to the professional managers initially. Then they should use the 10 to 20% of their money not given to the professional managers to test whether they can learn to beat the professionals and the index (usually the same thing). Only when they can demonstrate several years of beating the professionals and the index, should they consider increasing the proportion of their money that they manage themselves.

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