In planning a home for a family, perhaps the most urgent single requirement is a place to sleep. But if the family have any choice, how long will they put up with nothing but bedrooms? Such is the issue of diversification. For comfortable living, a family needs several rooms, each one designed and equipped for a different use. In making investments, many people seem to assume that one type will take care of everything. This is as sensible and efficient as doing the cooking in the bedroom, or park­ing the automobile in the living room at night. A typical family needs several types of investment.

A family with young children and meager savings may justifiably feel that insurance on the life of the income-earner is more urgent than any form of investment. But from this possibly sensible beginning many savers jump to the absurd conclusion that life insurance takes care of every­thing, from cradle to grave. The question of who needs life insurance, when and how much, is discussed in other chap­ters.

When the only goal is to build up as much capital as possible, an investor had better put all of his savings into common stock or other forms of equity ownership. In the course of his lifetime, by owning only common stocks, well chosen, and reinvesting dividends, a saver can accumulate more capital than by having all or any part of his savings in fixed-dollar items. Well, then, why not concentrate on com­mon stock? Why divide our capital?

A stockholder may get caught in a squeeze outside of his investing. If some event requires him to raise extra cash, he may be forced to sell stock at a low price. This is discussed in the preceding chapter called "Raising Extra Cash."

Uncontrolled emotions are another reason for not owning too much common stock. When stock prices drop, apparently a good many owners start worrying. If they don't act, their fears may not do any harm to their investments. But if they get so scared they sell out at low prices, then their long-range investment program has poor results. Presumably an emotional investor will not scare so easily if considerably less than all his savings are in common stock.

As an investor grows older, he has increasing need for care in balancing his investments. After retirement, in the absence of earned income he probably needs more income than he has, and this is an argument in favor of common stock. But if something causes him to sell stock at a low price, this cuts his future income worse than if he had sold some fixed-dollar item. And lacking an earned income, he has no way to recover his lost ground. So for diverse reasons, an investor owning nothing but common stock may some day wish he had put some of his savings into fixed-dollar investments.

Common stock and fixed-dollar items can be bought in combination. Some investment companies have a balanced portfolio, containing both common stocks and bonds or pre­ferred stocks. Thus one share in the fund combines some of the advantages of two or three quite different types of in­vestment.

Here we mention just one aspect of a balanced fund. If an investor sells its shares when general-stock prices are low, he will probably not lose as much as in a common-stock fund, but at the same time, he will lose more than if he sold a separate fixed-dollar investment. So when an in­vestor must sell something, shares in a balanced fund are not as good as owning two separate investments, one in common stock and one in fixed-dollar, and being able to choose be­tween them as to which to sell. This is where diversification comes to the fore.

What ratio to maintain between the value of common-stock and fixed-dollar items owned depends partly upon the nature of an investor's other property, and his income. A man sure of holding his job and his pay, come fair weather or foul, has less need for fixed-dollar investment. And a salary that is slow to rise when the cost of living goes up is a reason for buying common stock as a protection against inflation. Whatever the choice, some diversification is necessary.

Home-owning, being a form of equity ownership, some­what reduces the need for common stock. Owing a big mort­gage calls for more fixed-dollar investment, to make sure that mortgage-amortization payments can be met.

Assuming that the cost of living continues, as in the past, to show an average long-term tendency to rise, it is pretty hard for a man to maintain the buying power of the capital he has already saved, unless he puts more than half of that capital into common stock, real estate, or other equities.

When a man retires, his pension benefits are nearly al­ways fixed-dollar. To offset this, a large share of his per­sonal capital needs to be invested in stock.

Variety Among Common Stocks

Among fixed-dollar investments variety may have little point. This is where diversification is less important. On U. S. savings bonds, the possibility of the Govern­ment failing to pay dollars as promised is too slight to bother about, and the same is true of a deposit in a bank insured in F.D.I.C. So to the extent that a man desires that sort of investment, there may be no reason for buying more than one variety.

Common stock is different. When an investor buys stock in a good-sized corporation, ordinarily he is not interested in attempting to gain control of the corporation, and this eliminates the necessity for concentrating in the stock of one company. But what difference does it make whether he con­centrates or diversifies in common stocks? Answering that question is the task of the rest of this chapter.

The aspect of the stock market that attracts the most at­tention is the change in value of the prominent indexes, or averages. "The Dow-Jones Industrial is up 3.30." Such state­ments give the impression that the values of all stocks move in a similar fashion. To some extent, the prices of stocks do tend, at any one time, to move in the same direction. In a period of increasing prosperity or optimism, most stock prices rise, and in a time of shrinking profits or of pessimism, they go down. But at the same time, the price of any one stock is also affected by what speculators and investors know or guess about that company in comparison with others. Guarding against this is why diversification is the rule not the exception.

The Monthly Stock Digest, a pamphlet distributed through brokers to their clients, contains statistics on common stocks listed on exchanges. In the February 1957, issue it shows how much the price of each stock has changed since August 1953. We made a study of the first 100 stocks appearing in the Digest's alphabetically arranged list. We skipped two companies with incomplete records, also four investment com­panies, because their prices reflect the average of all the diversified stocks they own. We believe the 100 stocks in our study are fairly representative of the performance of all listed stocks.

Assuming that in August, 1953, we had made a $1,000 investment in each of these 100 stocks, in January, 1957, we found that on the worst-performing stock the value had gone down to $450, while on the best it had risen to $5,040, and on the other 98 stocks the value ranged all the way between these extremes. Most of the stocks rose considerably in price, because the time period included a stock-market boom. But the main point of the study was to show how individual stocks differ from one another in their price movements, and this tendency is present no matter whether the general mar­ket trend is down or up or level. This is important when looking at diversification.

An optimistic reader doubtless will react to our compari­son of results, by thinking, "Obviously the thing to do is to buy only the stock whose price will rise the furthest." A buyer is justified in taking this attitude, provided he realizes he is gambling, or he is egotistical enough to believe he knows how to forecast the trend in price of the stock he selects. Of course a gambler or an egotist may be right sometimes; the real test of his investing ability is how he comes out in the total of all his moves over a period of, say, twenty years.

A timid reader's reaction to the varied results among these stocks may be: "If some stocks actually drop in price, while the average market level is going way up, then evident­ly when the general level drops, some stocks show just about a total loss. If I buy stock, it might prove to be one of the bad ones, so I won't buy any." This fear of bad results might be justified if a buyer were limited to just one, or even to just a few stocks. But a timid reader needs to get acquainted with the possibilities of averaging by diversification.

Instead of putting $1,000 into just one stock, let us im­agine that an investor divided it up, in August 1953, putting $10 into each of the 100 stocks in our study. Such small-scale buying of these exchange-listed stocks is impossible, but later on we will show an equivalent and practical action. In January 1957, the value of the 100 stocks was $1,828. Obviously this value was far below the result with the best performer mentioned above, and it was also far above the worst one. In considering this result, remember that it was merely the average of an alphabetical list of company names, with no attempt at selection.

It is said: "One rotten apple spoils the barrel." But in a barrelful of diversified stock, one fine one can offset several bad ones. The best value among the 100 stocks, in January 1957, was $3,212 above the average, whereas the worst value was only $1,378 below the average'. The mathematical trick here is that the price of a bad performer can drop only so far, zero being the bottom limit, whereas a successful stock has no top limit. So the good ones tend to outweigh the bad ones.

Dividends are affected by averaging in the same manner as prices are. But the discussion here is limited to prices, because they move up and down faster and farther than dividends do, so that the effect of diversifying is more ob­vious.

Selective Diversification

A first-class job of diversification calls for a more intelligent selection than the alphabetical list we have been using. Often a company may have a good performance compared to its competitors in the same industry, but something is wrong with the whole industry. To avoid getting caught in a de­pressed industry, skilled diversification includes companies from a good many industries, such as automotive manu­facturing, building-material manufacturing, chemical and drug manufacturing, insurance, petroleum production and manufac­turing, railroads, electric utilities, and retail stores. The port­folio of a diversified investment company is apt to include some twenty-five industries. Within each industry, of course, a careful buyer selects the stock of those companies which he estimates will do the best. For instance, in petroleum pro­duction and refining, he must choose among Gulf Oil, Stand­ard Oil of New Jersey, Shell Oil, Socony Mobil Oil, Superior Oil, Texaco, and many others.

Geography is another aspect of diversification. A large American corporation generally does business throughout a considerable portion of this country, so that a buyer of the stock of such a corporation automatically obtains regional or national distribution. In principle, thorough diversification calls for owning equities in businesses in several nations be­sides the United States. But in other nations, except for Canada, the mechanism for investing in corporate stock is not well developed, compared to the ease of obtaining infor­mation and of diversifying among industries and corporations having their headquarters and doing most if not all of their business in North America. And in many industries, the volume of business done by American corporations is a large portion of the worldwide volume. But foreign opportunities are increasing and may expand considerably before many years.

How many stocks are necessary for adequate diversifica­tion? Obviously the risk of loss is less with two stocks than one, is less with five than two, and so on up. But a small investor, trying to own stock direct in a large number of corporations encounters practical difficulties in the size of broker's commissions he must pay, and in keeping himself adequately informed.

A typical investment company owns stock in from 50 to 100 corporations, and an individual can obtain this spread merely by owning shares issued by one investment company. This is the practical way for an ordinary saver to obtain first-class diversification.

An investor's need to diversify among common stocks depends partly upon his emotions. A man leading a dull life and demanding thrills in his investing certainly will find more excitement by concentrating on one highly volatile stock. But plenty of other possibilities for excitement are open to him. He might bet on horse races and sports contests, setting a limit on how much loss to risk each week, and having thus satisfied his demand for thrills, he could proceed calmly to invest his lifetime savings in a manner that reduces risk to a minimum.

Another type of investor is a natural worrier; the writer is a full-fledged member of this group. Experience has taught him that being able to sleep soundly at night is pretty es­sential for a satisfactory life, and owning a diversification of stocks is quite a help in avoiding insomnia!