NOT putting all our eggs in one basket, both literally and figuratively, is smart. It helps us sidestep the insidious trap of embracing too much concentration risk in the hope of growing rich fast.
There is no doubt that concentrated investments in just a few stocks or (worse yet) in only one, can conceivably help us profit enormously, especially if they (or it) happen(s) to be multibaggers.
The term "multibagger" was coined by the legendary manager of the Fidelity Magellan fund, Peter Lynch, in his value investing 1988 classic book One Up on Wall Street. But the term is unfamiliar to most Malaysians because it stems from baseball, a game I've never seen played here.
Still, understanding what Lynch meant is easy.
Let's say you buy a stock for RM5 a share, and over many years its price soars to RM10 and later to RM20. We would then refer to those two happy higher valuations as representing twobagger and fourbagger price points because, based on your original purchase price, you would have first doubled your money for a 100 per cent gain (RM5 to RM10 or RM5 more per share) and later quadrupled it for a 300 per cent gain (RM5 to RM20 or RM15 more per share).
Such experiences are what all investors, speculators and gamblers dream of. And as a longtime investor in both domestic and overseas markets, I have experienced a few multibaggers in specific stocks. But we never know in advance when a stock purchase turns out to be a rocket to the stars or a depressing lemon that crashes to Earth and craters our plans.
So, for my more serious money — meaning larger sums earmarked for a crucial long-term goal like retirement — I take for myself, and for my financial planning clients, the slower, surer, more boring route of diversification.
BENEFITS OF DIVERSIFICATION
Concentration is much better when it works but it usually fails because of the high statistical chance of either mediocre returns or utter loss.
Diversification, though, while less adrenaline-pumping, has a much better chance of helping us grow our money slowly, steadily, and more surely.
The benefits of diversification are further augmented when we overlay this wise investment strategy with the discipline of dynamic asset allocation.
This hinges on rebalancing among various investments to increase the probability of implementing the ultimate strategy for making money: buying low and selling high.
Retired United States Marine officer and jet pilot turned investment professional and author Richard A. Ferri wrote a book I've had in my office library for 15 years: All About Asset Allocation.
In it, Ferri, also a CFA or chartered financial analyst, states:
"Diversifying across many investments that are dissimilar and rebalancing those investments to their original target at the end of the year can reduce the annual volatility of the portfolio over time by enough to increase the compounded return. This 'free lunch' from rebalancing is the essence of modern portfolio theory."
POINTERS TO HEED
In my own professional practice, and each time I am asked to take the stage at a financial planning or retirement funding event, I explain to my clients and audiences that there are three dimensions of investment diversification we should all heed:
1. Diversification across various asset classes;
2. Diversification across different geographic regions, and
3. Diversification across a long timeline.
To leave you with usable pointers on all three dimensions, let me elaborate on each:
1. When I construct a diversified savings and investment portfolio for clients, I typically utilise as their building blocks domestic, regional, and global funds that grant targeted exposure to three, four or, ideally, five different asset classes. My full selection suite — or menu — of five asset classes exactly matches those tracked for analysis in the annual WWR, or World Wealth Report, published by Paris-based wealth management consultancy Capgemini. These are cash, fixed income, equities, investment real estate, and alternative investments.
2. I also encourage my clients to avoid national, specifically Malaysia-focused, concentration risk when considering which portfolio building blocks to use. That advice has helped my clients avoid the worst effects of the steadily weakening ringgit over the last several years. However, since most of them are Malaysians, having a portion of their portfolios focused in this country and denominated in RM is sensible since almost all their expenses are denominated in our currency. It is also wise to spread out the geographic risk of their portfolios by investing both regionally across the Asia Pacific and globally across as much of the Earth's surface as is advisable while intelligently avoiding countries or regions lacking potential because of war or incompetent leaders.
3. Two investment strategies that bring down the weighted average cost of well-chosen investments with fluctuating prices over many years are DCA and VCA, dollar-cost averaging and value-cost averaging. (To read more about those, visit me at http://rajendevadason.com/free-articles/2012/10/30/deciphering-the-dca-v....)
So, take a hard look at your efforts to grow wealthier by saving and investing. Then ramp up your discipline. Finally, decide if you've been too concentrated in your approach.
If so, diversify — widely and wisely — as you reach for compounding profits.
© 2024 Rajen Devadason
Rajen Devadason, CFP, is a securities commission-licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via rajen@RajenDevadason.com. You may also follow him on Twitter @Rajen Devadason and on YouTube (Rajen Devadason).