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Rekenthaler Report

The Drawback of Diversification

Its lunch is indeed a bargain, but it's not quite free.

Skewed Results
The practice of diversification is justly popular, not only because it reduces portfolio risk but also because, at least for equity investors, it improves the odds of landing a winner. Most stocks disappoint. Equity funds thrive not because they hold many stocks that perform well, but instead because their relatively few successes outweigh their more-numerous failures. After all, a stock can only lose 100% of its value, but it can gain a great deal more.

Statistically, this condition is termed "positive skewness." Under a normal distribution, as many subjects exceed the norm as trail it. With positive skewness, however, most subjects lag the average, which is bolstered by the happy few. For example, 50 students graduated from Wake Forest University in 1997 with degrees in psychology. The average career earnings for those graduates now stands at $6.5 million--thanks to the one student who made $250 million.

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