Cramer writes as he speaks: a little too cocky, self confident, straightforward, candid, and with a couple of “insider” jokes that make you think he is the only one that finds them funny. It is a great flight book (that is a book to read on a boring 6 hour flight). That being said, the book is a good collection of sane (yes, I said sane) advices for the novice and no so novice investor. His stock-picking rules are a good organized way to summarize the basics of disciplined investing / trading. I have two pet peeves on his recommendations: the way he defines diversification (which is not exclusive of Mr. Cramer), and the 5 stock limit for part time investors. Let me explain.

I am not saying that you shouldn’t diversify, but diversification is different for each investor. If you call his show to the “am I diversified” segment and tell him: “I own EBAY, GOOG, AAPL, CSCO, and QCOM” i can hear the screams all the way from here: “They are all tech!!, are you crazy????” The firs statement is true, the second … well, I don’t know for sure, but not because you own those stocks. EBAY is really online retail, Google is advertisement; Apple devices; Cisco, infrastructure, and Qualcomm, chips. True, there may be some correlation between them, especially between QCOM and AAPL (iPhone uses silicon chips). But based on fundamentals they really address very different markets and their revenues are not so closely tied. Technically, they might be closer since most investors aren’t tech geeks so they think they are tied together more than they really are. If you work in tech like I do, you can distinguish the differences between these sub-categories and be diversified within a sector. Moreover if you work in tech you have to monitor these companies.

Cramer also suggests to own a minimum of 5 stocks to consider diversified, and he even goes through rules of how to pick the categories of these 5. He also suggests that more than 5 is too many due to the “buy and homework” strategy, arguing that you can’t devote enough time to do homework on more than 5 stocks and still have a day job. My opinion is that like everything else in life it depends. Following on my example above I have to know about the 5 companies I highlighted below for my day job, so I can afford to own stock of more than 5 if I can dedicate my moonlight hours to do “homework” outside of my area of expertise.

One last comment: I think Cramer overlooks one additional cardinal rule of investing. That is keep a balanced portfolio. Diversification doesn’t mean a lot if you own 5 stocks but 80% of your portfolio is in only one. Index funds that follow the Dow Jones or S&P are another fallacy of proper diversification like I explained here.

Enjoy.

We hear all the time that investing in stocks is the best way to grow your money in a passive way.  Over the long run stocks have always outperformed other asset classes.  hmm…  let’s see:  The Dow Jones Industrial Average (DJIA) closed at around 380 points on August 1, 1929 with a volume of some 3.8 million shares.  80 years seem like long term, right? $1000 invested in the DJIA on August 1, 1929 will be worth today, May 1, 2009 $21, 529 with a volume of around 10 billion shares.  Pretty good.  If we assume a 3% inflation rate for 80 years, it is equivalent to $2029 in 1929 dollars.   The chart on top shows our inflation adjusted grand invested in August 1929, of course backwards.  We doubled our money in 80 years! It doesn’t seem like a lot, now does it?

But don’t worry by July 1954 (25 years later) you will have your $1000 back.  The DJIA closed at 386 points with a volume of  roughly 3.3 million shares.  Of course, discounted for inflation it was really the equivalent of $486 1929 dollars.  By Christmas 1963  the Dow closed at 783 points with an impressive volume of 5 million shares.  You now have $2006 (or $734 1929 dollars), so let’s keep going.  By March  1983, the 1100 points of the Dow meant $3000 ($602 1929 dollars).  In January 1987 (yes 58 years later) you will finaly have the equivalent of $1000 in 1929 dollars ($5600 1987 dollars) just to see the market fail on you by November.  But worry you not, a year and a half  later you’d be back to your grand in March 1989 (2342 points and a volume of 177 million shares).  You’ll be cruising through the nineties to double your money by March 1996 when the volume was reaching half a billion shares and a close 5580 points.  That is really where you are today.  If you’re curious, the memorable peak of December 2007 of 13500 points will have meant roughly $3500 in 1929 dollars.

In my opinion, this is really amazing.  According to Wiki Answers, the base price of Chevy AC coupe in 1929 was $695.  So your humble $1000 could have bought you one with $305 to spare.  Your $21,000 of 2009 may buy you a Pontiac that may soon belong in the Smithsonian.  The Nissan Versa, the least expensive car in the US is worth around $10,000 according to Edmunds.com. so maybe you’re ahead a little bit.  The point is that popular wisdom of investing in an index and forgetting about it may not be the best for your money.  I know, I know, I picked the worst possible date to invest my humble grand, but it makes the point I want to make.  Manage your investments, because if you started in 1999, you’re still behind today.

In case you’re wondering, the volume figures have no influence on the dollar values, but I found extremely interesting that multiple billions of shares change hands every day  just  on the 30 components of the Dow.  The popularization of stocks is amazing, but also dangerous, but that is a topic for a different post.

Enjoy.

Dow Jones price weighted averages

If you are invested in a fund that follows the Dow Jones Industrial Average (DJIA) the chart on the left shows the percentage allocation you had on February 23, 2009 by index component.  You may think you are diversified, which is true, but you are by no means balanced.  10% of your investment is in IBM shares and less than 1% is in GM.  Although you may be thankful for the latter it makes the point that you are not balanced at all.  This has to do with the way the DJIA is calculated.  Diversification is all you hear from Cramer to Orman to your local financial adviser. The indexes, major indicators, or SMIS (Security Market Indicator Series) like the Dow Jones Industrial Average (DJIA) or S&P500 are a sure way to diversify since buying into them means buying 30 or 500 companies from technology to financials to automotive (good luck with the last two).  That is fundamentally correct. However, the way the index is calculated is the trick, especially in times of turmoil like the present.

According to Forbes’ Investopedia (http://www.investopedia.com/articles/02/082702.asp) the Dow is a price-weighted index which means that it gets calculated by simply adding up the price of each of the 30 stocks divided by a “constant” called the Dow divisor. For those of us that are geeky its current value is 0.1255527090.  For example, according to Yahoo Finance (http://finance.yahoo.com/q/cp?s=%5EDJI) the 30 DOW components closed on Feb 23th, 2009 as follows:

So the DOW’s pathetic 11-year low is calculated by adding all these stock prices and dividing by 0.1255527090 = 7114.780773.   Besides wiping down 11 years of “growth” it has done something more relevant: it has made some components more important than others because they have lost less. If you compare the influence of IBM vs. Citigroup (C), the former at 84.37 and the latter @ 2.14 (after an almost 10% rally, mind you) you’ll see what I mean. A 10% gain in IBM will mean around 0.94% in the Dow whereas a 10% gain in C will only mean a 0.024% in the DOW. in other words, C needs a 417% rally to have the same effect as a 10% IBM gain. I don’t think that the bailout can pull that off but I think you get my point.

Is there a good strategy for balancing better? you’d think so, since financial and automotive have been hammered, they have been sent to the bottom of the list.  Now let’s think what tha means for your investment.  For simplicity, let’s create a hypothetical nonexistent date where all 30 stocks’ prices open at $10, the DJIA will be at 2389 (let’s pray it is not in the future).  Two investors with $3000 each decide to invest in the DJIA that day.  Investor A buys an index fund that follows the DOW and buys 125.55 shares at $23.894 each.  Investor B buys 10 shares of each of the 30 companies.  If both remain invested that way until Feb 23, 2009 they both now have  $8932.80.  Investor A still has 125.55 shares at $71.115.  Investor B now decides to re-balance her portfolio to hold equal dollar amount per share.  The new portfolio will look as follows:

We now move to March 13 ,2009 where the DOW closed @ 7223.98.  Investor A will still have 125.55 shares, now at 72.24 or $9069.70.  Investor B however has $350.56 more with a portfolio that looks like this:

Why?  Because she sold high to buy low; the first rule of investment.  She still gets dividends and she is still invested in blue chips (not quite a warranty these days) and she is exposed to a similar risk.  Of course this case is hypothetical and has conspicuously ignored trading fees that will more than wipe $350 with at least 40 trades.  But I think it illustrates the point.

The S&P is a market cap weighted average so its calculation is different but the principal still applies, of course planning to trade all 500 shares will be cumbersome, expensive, and perhaps stupid.

Enjoy