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To diversify or not?

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According to the online dictionary to diversify is to 'distribute (investments) among different companies or securities in order to limit losses in the event of a fall in a particular market or industry'. So the primary reason why diversification is needed is to limit losses in the event of a fall.

However, I would like to think that another reason why diversification is needed is because you want to make money from your investments. If you had bought nothing but Enron stock or some other big companies that later went bust because you are the employee and so you buy into the company faithfully, then you would have seen all your money disappear into thin air. That is the only reason why you need to diversify. Because you want to have more than you put in as an exchange for taking up the risk of investing in the stock market. Or else, you might have as well put money under your pillow or in the banks and earn a puny return in exchange. If, instead of putting money into one stock or fund, you put it into a few stocks or funds, even if one goes down, the others will help to minimise the losses so that hopefully you earn a positive return.

My teacher told us that there is no free lunches in the world. So what is the catch? Well the catch is simply because the risk is lower, your returns is also lower. Why is that? Imagine if you had invested all your money on just one stock either Berkshire Hathaway or Microsoft or in Singapore you had invested it on either SGX or DBS bank during the IPOs and held it till today. You would have made a lot of more money rather than buying a few other stocks which will pull the average returns back. A look at the top people who are the richest people in the world will show that these people are rich because they are specialist in one field and got rich through having just that stock. However, I remember reading that if you look 5 years later, most of the people who are the richest in the world now will not be in the list.

So what should you do? Warren Buffett said that a good investor only needs to buy 6 stocks and understand these companies stocks well and monitor them, any more and it is overkill and will erode your returns. Thus, I am not going to argue with the greatest investor the world have ever since who has proven his mettle since 1950s.

I would like to add here is that being truely diversified means that the 6 companies that you buy must be in different fields with as little correlation to each other as possible. This means that if you have one bank stock you should buy another bank stock in the same country because they would correlate with each other since they are in the same industry and same country, also you should try not to get another related stock, for example a finance firm like Hong Leong Finance, which although not a bank would be closely related to banks' price movement.

For unit trusts or mutual funds, an investor needs to diversify the holdings too. A starting investor with not too much money can buy just one fund, but if you are buying with say $20,000 or more, it is time to diversify into two funds. However, unlike the stock example, I would think that you should be holding no more than 4 funds as the funds itself is already diversified into different shares. So there is not much benefits from holding 6 funds as in the stock example.

I believe diversification is the most important thing an investor needs to do in planning for your investment. Remember stocks and managed funds are risky already compared to bank deposits, so hedge your risk by diversifying your investments.

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