Hedge Funds – Hedge Your Bets

| December 7, 2007 | 0 Comments

Just this week, I received a call from Robert, a hedge fund manager in California.  We have known each other for quite a while and this guy has been very successful at what he does.  While I don’t know exactly how much money he manages, I would estimate it to be around $50 million.

No small pocket change but small by hedge fund standards.  Most of the money is his, but he also has a few outside investors.  Now, you and I can’t invest in his fund as he only takes money from his friends – who are very, very rich.

Robert has a risky style of investing that up until now has served him well.  He takes very concentrated positions in all of his investments.  He focuses on micro-cap companies because he knows them best. Sometimes he will hold as few as 7 or 8 stocks.  To make matters worse, he often adds leverage to the portfolio by borrowing money to invest. Clearly his fund is not for the faint of heart. It works great when everything is going up. But alas, everything doesn’t always go up…

Early this year one of his investments went bad. Management couldn’t deliver the sales that they had been promising. The customers liked the product but were delaying orders for one reason or another. The company started bleeding money and was on the verge of bankruptcy. The stock price plummeted.

I don’t care who you are or how much money you have – situations like these are very painful and gut wrenching.
With his concentrated portfolio, Robert’s loss was devastating.

Significant losses like these are extremely difficult to recover from. In Robert’s case, a fundamental loss of a single investment destroyed as much as 16% of his total investment portfolio. This is why we advocate a diversified portfolio investment strategy (regardless of what you’re investing in).

Now there is a risk of being too diversified. Owning too many stocks, options, or commodities can be a bad thing as well. For example, if you own 1000 different stocks the returns on any single investment are so diminished you eliminate any chance for outsized gains on your portfolio. If you have a stock that doubles in price the resulting profit in your portfolio is limited to 1/10th of a percent.

Every person needs to look at their own investment profile and risk strategy to determine how diversified they should be. Typically, this can range from 25 to 50 holdings or more. In The Options Forecast for example, we encourage investors not to put more than 4-5% of their total options trading capital into any single investment.

As our call ended, Robert mentioned that he had more than doubled the number of stocks in his portfolio. If he would have done it sooner, he may have saved himself and his outside investors millions.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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