Don't Put all your eggs into one Basket?

Discussion in 'Trading' started by mastersuniverse, May 24, 2009.

  1. It is obviously unwise to put all your eggs in one basket, as you would risk losing all your eggs if you drop the basket. Equally, it would not be wise to go to the other extreme – over-diversification. By over-diversification, your money is spread around so thinly that all you would get is “market return”. Worse still, it would be impossible for you to keep track of your investments, meaning that you don’t really know what you are getting into.

    Consider a good value stock that is trading at a large discount to its cash value (they do exist, if you look hard enough). The prospect of the company looks promising and the management seems honest. Would you put all your money into it? Instead of putting all your eggs into one basket, you may decide to play it safe and only invest 5% of your money into this stock. One year later, the stock price tripled, however your overall portfolio only made an extra 10%. Why have you not made a killing having identified a three-bagger? In the name of diversification, you have placed most of your money into blue chips and bonds, which are just earning you market return.

    The general rule is that the more you diversified, the closer you get to market return. If market return is all you are after, why invest in hundreds of different financial products offered by your investment advisor? You are far better off buying index funds and pay the nominal management fees.

    It is clearly unwise to put all your eggs into one basket, but it is equally unwise to over-diversify, especially into something that you don’t understand. Diversification means that you will only be losing a small proportion of your overall net worth if one investment goes sour, but the more you diversify, the probability of each investment going sour increases, especially if you don’t really know what you are getting into. By investing in a series of dud investments, these losses would add up and affect your overall return.

    What is the optimal level of diversification? There is no hard and fast rule but just enough for you to keep up with your investments. Managing risk is a matter of how well you know about your investments, and not the number of investments you make. Warren Buffett outperforms everyone by investing only in a handful of stocks that he understands. Concentration is only a risk if you don’t know what you are getting into.

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  2. Those are "deceptions".
    1) Managing risk has to do with having an exit strategy that you adhere to. You don't have to know nor need to know anything about your investments.
    2) Buffett doesn't outperform everyone. When he's on his deathbed, BRKA & BRKB should collapse because of expected liquidations in the portfolio for estate taxes and heir stock sales. That can bring the long-term annual rate of return back to "average" of these days.
    3) Concentration is a risk if you don't have an exit strategy that you adhere to. You don't have to know nor need to know what you are getting into.