Trading Desk: Diversification 101 (Advanced)

Every market player learns the one about the eggs and the basket early on. But believe it or not, diversification is more than virtuously spreading your funds across “baskets” to avoid one catastrophic collapse. Some of my subscribers now have first-hand experience of how this can actually be one of the most pragmatic investment tricks of all.

The secret here is that spreading your bets shields you from going all in on a losing hand. It’s really that simple. Maybe you like a particular commercial innovation or theme, something happening in the economy. But nobody knows which particular company will end up outcompeting all rivals and leaving them in the literal dust.

There will be a winner. That winner will win big. And there will be a lot of losers. The lucky ones will pivot out of that particular business and find new pastures elsewhere.

The rest will simply cease to exist as credible investments. Their share of the big future you envision drops to zero. For all practical purposes, the stocks could too.

The survivors absorb the losers’ share of this vibrant and presumably expanding market. The market itself (your theme) keeps growing. The pie the survivors get to share grows with it.

That’s what I think of when it comes to eggs and baskets. When you know a basket is expanding, make sure you collect all the eggs you can. This is why index investment strategies have such staying power. When you index a growth industry, you grow.

And a fragmented initial portfolio hardens around a handful of big players dominating a basket full of little eggs that never really “hatched,” if you like. This isn’t about virtue. The logic is actually pretty cold: buy the losers but don’t mourn them because they will die. The winners will do so well that you forget the losers even happened.

We’ve been learning this in my IPO Edge, which focuses on stocks that have come out in the past year. It’s still a rough time on this end of Wall Street. A staggering number of deals are still breaking . . . 60% of the companies that made it out of the pipe YTD are underwater and some are down as much as a harrowing 80% in a matter of weeks.

Those stocks effectively broke like fragile eggs on entry. And yet IPO investors who bought every single deal are still smiling because there are enough clear breakout winners in the mix to lift the overall return on the group to about 13% YTD.

If you bought every single IPO this year, you’d be staring at a lot of broken eggs. And you’d be smiling because you’ve still made as much money as the S&P 500 in a typical year . . . in a matter of weeks.

This is how it works. My IPO Edge subscribers have swallowed some horrendous losses along the way, especially last year when, you know, the pipeline was crowded with companies priced for the zero-rate COVID world and the Fed crushed deal after deal.

But you can only lose 100% on any position. You can gain 100%, 200% even thousands of percentage points when you give a winner enough time to grow its basket and absorb capital from weaker rivals.

That math is positive. And that’s why I urge my IPO investors in particular to obey the diversification rules. It’s not just a good idea. It’s not the right thing to do. It’s how you make money in a world where a lot of perfectly good companies die for no fault of their own.