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Cuban on Investing: Diversification Is for Idiots

Entrepreneur Mark Cuban sits down with the Journal’s Alan Murray and weighs in on the fluctuating market. Cuban is investing in volatility. He believes "buy and hold is a crock of $%#!" and diversification is for idiots. Cuban also addresses how patent law stifles creativity, but refuses to address the NBA lockout.

Some of his best advice to the average investor is to pay off your credit cards and use your cash to buy large amounts of consumables at a discount that you know you will use. This is actually very good advice. If you eliminate your expensive debt that will save you 15-25%. If you spend 5-10% less on products you will definitely use by buying in bulk, that is a direct savings.

I don’t want to be accused of being Chicken Little and warning the sky is falling but we are entering a time when the market could go down dramatically.

As I write this, the US government is getting very close to not raising the debt ceiling. Most pundits expect that a compromise will eventually be reached and "Armageddon" will be averted. It appears that by Monday, August 1, 2011, this will be far from certain. By August 2, the markets will be a mess if the US government doesn’t have the money to pay bills. While it is possible that some stocks will do well in that scenario, the biggest likelihood is that the entire market will go flat or have a significant loss.

So what should a Confident Investor do in this situation?
The thing to remember is that cash is king! You will not lose money in the stock market if you are not in it. I wrote a popular article many months ago about the benefits of sitting on your money when you are concerned with the direction of the market. Here are my suggestions for August 1:

• Sell every stock you own. Yes, that is extreme but it is the safest way to insulate your portfolio from government inaction.
• If you don’t like that advice, if you have a profit in an individual stock, lock those profits in by at least selling your principle. If you want to leave your profit in the stock and put your principle back into the bank you will at least not lose your hard-earned money.
• At least, cut your exposure to your largest investments by selling half of your investment.

Let’s examine the risks in this strategy
For this analysis let’s assume that you own 10 high-quality companies such as those found on the Watch List. Let’s assume that they are each $50 per share and you own 100 shares of each. To sell these 10 positions you will be out $100 (I am assuming you have chosen a broker that charges a reasonable fee for a transaction e.g. $10 or less)

1. The market is flat and nothing happens. You buy back into your holdings at approximately the same price.  You are down $200 for a round-trip and a little piece of mind.
2. The government doesn’t do a deal and the market appreciates slightly. I doubt this scenario will happen but there is a chance. On a typical good week, the market might go up a couple of points but since you have great stocks, maybe they go up 3% and you missed out. To buy back in you are out the $200 for your broker and 3% of $50,000 for a total of $1,700.
3. If the market tanks by 15% (a very real possibility for the short term) and you buy back in at an average of 10% lower when you are confident that the worst is over then you have made money. In this case, you will buy 10% more stock for your 50K and since you are invested in great companies like on the Watch List, your stocks will eventually grow back to their present value and you will have made $5,000 (minus the $200 for the broker so a net of $4,800) off of this government screw-up.
4. If the market thinks this Armageddon is not a big deal and only drops a paltry 3-5% then you will essentially break even since you will wait a week or so and much of the 5% will recover to maybe a 2% loss when you rejoin. This means you will buy back in for a net of about $800 which is essentially covering your costs and headache of managing your portfolio so closely.

When was the last time you were extremely confident that you were at a short-term high price and the stock was going to drop significantly? Be cautious on Monday and make money. If number 3 above happens, you would have an approximately 10% increase in the size of your portfolio just by doing some solid money management.

Why should you wait until Monday?
To be honest, if you have a lot of profit on a stock then maybe you shouldn’t. No reason to get greedy. Sell your holdings now if you are very concerned and think there is little chance of a deal. However, if the US government puts together a solid plan over the weekend when their backs are against the wall then the market may reward them. A good deal that gets wrapped up on Sunday could see a several point move early in the week. I would hate to see you miss that move by being too cautious. If you are scared though, I cannot blame you from moving on Friday.

Also, any deal on Monday is likely to not be very compelling. It might avert a debt ceiling but it likely will not harbor great changes in ways to avert the problem in the next year. This means that a deal on Monday will probably not make the market move up greatly. Only a deal during the weekend will be complete and tough enough to make the market move.

Mutual fund strategy
If you own a mutual fund, your options are far more limited. By buying a fund you are relying on a smart manager to take care of your money. The problem is that manager cannot react too rapidly to this situation due to the large amount of invested capital. Selling a large chunk of shares in any one company is difficult for a fund manager as it causes a market reaction and the price of the stock drops. Also, since your fund selling is not transacted until the end of the trading day, Monday may be too late.  If you want to reduce the exposure in your stock based mutual fund then you may need to do your selling on Friday.

Other options
I do not recommend to any Confident Investor that they short a stock, but if you are so inclined then this may be an excellent time to evaluate this strategy.

Some investments may appreciate so you might want to take a risk. I would avoid any companies that get a lot of money from government or are very cyclical (think defense contractors, oil companies, transportation companies, and farm management companies). You may also want to avoid companies that make a product that the government buys (think construction equipment, big construction companies, etc.). Also, if interest rates rise dramatically then any company that needs to borrow cash on a regular basis or does not have a lot of cash in the bank should be avoided. Companies that do well when the US government is screwed up MAY take a quick uptick though (think gold).

Warning
With all of this, there may be tax consequences. If you are concerned about the tax consequences of your move, I suggest you approach a tax adviser.