Diversification? Or Diworsification?
So what is diversification in stock market investing? We don’t know what the future holds. We don’t know if Google (Alphabet) will win the advertisement industry or Facebook (Meta now) will. Will Apple lose market share on mobile market or will it gain more market by new innovation? Will Microsoft continue to invent the next big thing? Or this time around it would be Amazon? Or another small company will be the next Microsoft?
Since we don’t know the answer to these, we buy a little bit of each, so if any of them win and make lots of money we can have a share in the profits.
It’s a sound idea and works all the time. But is there a better way? Spoiler alert, YES THERE IS.
Let’s say you have 1 million SEK and split and invest all of it in 100 different companies equally. Your portfolio would look like this.
What happens if 5 of those companies go bankrupt and their share value go to zero? (it won’t but let’s say it will)
You can’t even see the difference, right? That’s because it is the same image😅 “Bazinga”. Here is the actual 95 remaining companies.
I bet you still can’t see a difference, but believe me this time they are 95.
What happens if one of those companies operates very well and doubles in value. It will look like this.
It is still hard to find the company that operated better than the crowd and it won’t make you way richer than before (only 1%).
But this time let’s divide the 1 million SEK between 10 companies.
If one of them goes bankrupt and losses all its value it looks like this.
There is no way to trick you now, you can obviously see the change and loss of money.
And if one doubles too you can see the gain (and become 10% richer).
So by increasing the number of companies you invest in (diversification) you are protecting ourself against loss of capital, but you also lose on our gains too. Which one is better? The answer is simple, “It is different for every person”.
What is best for me you ask? It depends on your goal and what you want to do with your life. You should never buy 100 companies yourself. You can’t keep an eye on 100 companies and won’t know which one is going bankrupt and even if you want to probably you don’t have time to do it. You have a day job, a family that you prefer to spend time with instead of reading financial statements. And you have to pay fees on all those buys so it does not make sense financially either. So the best way is invest in well managed low fee funds. Funds are like baskets of stocks with a manager and a team of analysts looking after it and selecting the best of the best. Each fund may have thousands of stocks so by buying a couple of funds you will make money whenever each of those companies make money and protect yourself on the downside too. It will be an average return but it reduces the chance of capital loss too. The average return stock market can give you is 8 to 10% yearly. There are 3 keys here:
- Low management fee funds: Lots of funds charge you 10% per year to manage your money. They do lots of research, employ lots of analysts and pay high salaries to them. Avoid those, there is no guarantee they can make you 20% every year so after fees you are left with 10%. There are lots of market tracking or low management fee funds out there with fees around 1%. Try to diversify over them and buy a bunch of good ones.
- Dollar cost averaging: Never invest a lot of your money in a single time. Try to split it up and invest it over time. And try to do it monthly whenever you get your salary or have excess cash. Try to make it as automatic as possible. Remember you didn’t want to spend time researching companies. So you should not spend time on this either. Many brokers have plans to deduct money from your bank account and buy specific funds for you. (Read this tweet of me for an example of why dollar cost averaging is good, thou it is in Farsi😅 but Google translate did a good job)
- Rebalancing: Let’s say you choose 10 different funds and split your money equally between them. After a year or so probably one will out perform the others. Sell part of that one and buy more of those that are lower. This way you are automatically selling overpriced stocks and buying undervalued ones. You should not do this very often thou. Because it will take time and selling and buying probably cost you money too.
This way you will have an average return and can focus on the things you love (your job and your family for example) and let your money work for you.
So what is Diworsification? Warren Buffett says “diversification is protection against ignorance. It makes little sense if you know what you are doing". What he means is by buying lots of companies you are protecting yourself on the downside but lose lots of upside too.
When you love to read about companies, really know them and only then buy the best of the best (that has these characteristics) does it make sense to diversify just for the sake of being diversified? If you have 25 good ideas, does it make sense to invest the same amount of time on the 25th as you are willing to invest your time on the best? If your number 1 idea has a better chance to make you more money it does not make sense for you to invest your time to work on your 25th idea which has lower chance of creating less money for you. The same applies to stock market investing. When you have a list of 25 companies you wanna buy, it make sense to put most of your money on your best ideas. The good thing is then you have a few fantastic companies to watch and follow every step they make, know them and buy them at a great price. Instead of not having all your eggs in one basket (diversification), you will put all in one and watch that basket like a hawk.
If you look at some of the super investor on here you will see what I mean. To share a few:
There are some formulas that you can use to know what percentage of your money you should invest in your ideas depending on the probability of return you see in them, but we are not gonna talk about them right now. Maybe another day when we have a short list of companies to buy.
To sum it up if you don’t wanna spend time researching companies don’t buy a single stock. Buy well managed low fee funds over a long period of time and regularly. If you like to research companies buy as few as possible and as infrequently as possible. Wait for the fantastic companies to reach a great price and then go crazy on the buying button. It will do wonders on your return (yearly average 20% or even more).
Hope you enjoyed this story and it was useful for you. Let me know if you have any questions and I would love to clarify any missed points. See you on the next one.