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Investment Myths - Myth 2: You MUST Diversify Your Investment
Egg in the basket
Myth 2: You MUST Diversify Your Investment
There is a common myth that diversification is an effective risk minimisation investment strategy.This technique requires you to spread out your investments into different securities or different investment types to avoid a complete loss of funds if a disaster were to strike a certain investment. To some extent, this strategy is beneficial in reducing financial risks, and it does seem to appear to be common sense when you look at investments from an overall perspective. Your financial adviser may have suggested the philosophy: ‘don’t put all your eggs in one basket’”. However, the truth is, this technique has very little to do with making profits, and the target of investment is to maximise profits! Achieving maximum profits is also a way to minimise potential losses.
I would suggest you do not diversify for the sake of diversifying, as the more stocks you hold, the more likely you are setting yourself up for holding a weak stock. Those weak stocks will bring down your overall portfolio's performance. If you don’t understand and can’t value a stock, don’t buy them. Am I saying don’t diversify your investments? No, that is not what I mean. We do not diversify for the sake of diversifying! If we start to learn and invest the top performing stocks, eventually you will realise holding a few stocks with a stronger financial base will actually give you a better return in profit, rather than holding many stocks. This is because having more diversified stocks will increase the chance of you having one or more weak stocks and due to the nature of these stocks’ weak financial basis, they are more likely to cause losses, in addition to having a less ability to bring in maximum profit . However, the number of stocks and which companies to invest in involves constant analysis and reviewing of your assets and performance. Remember, ignorance is not a bliss!
Example: My friend James
My friend James was taught to be diversified as a manufacturer. Twenty years ago, the products he was manufacturing varied from clothes to homewares, to toys and finally,processed foods. However, there were always different costs in various areas which reduced his potential profit in other areas - for instance, the increased cost of raw material for processed food and his company’s lack of specialisation skill in toy making always prevented profits from coming in. As a result, the was always broke. Afterward, he has learnt from his mistakes and started to focus on specialising. Because one’s resources are limited, and you need a lot of resources for each “item” to “take off” and bring in profits, it’s always wise to focus resources on the specialised items.
James got rid of the toys which were poor quality due to his lack of specialisation and the costly raw material of food products. As he started to change his strategy, he spent more of his capital (made available from cutting off the other two products) and time on his homeware and clothes businesses, which were now able to bring him more profit than when he focused on four products. As a result, his profits were much higher than ever before and his whole business operation increased dramatically in effectiveness. This was because the money was transported to be utilised in the most effective places (the homeware and clothes instead of the food and toys) so that it could have a higher-yielding return rate.
To summarise in a sentence, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” Warren Buffet
Again, we do not diversify for the sake of diversifying. Keep the profit making securities and get rid of the poor performing securities from your portfolio. Keep your portfolio within a manageable size. Constantly review and analyse their performances to maximise your profits!
Please follow us on our next topic: Bluechips.
Many people believe that if we invest the money on blue chips, it won’t go wrong. e We will discuss investing on blue chips, and analyse some examples in our next article.