Diversification vs diworsification

During this recent market upheaval arising from the sub-prime issue. I re-learnt the lesson about investing only money you can afford to lose and also about diversification.

What is diversification?
Diversification is about not putting all your (investment) eggs in one basket. Metaphorically of course! What it means is that when you are investing, you may want to consider putting your money into different asset classes. For example, I do not allocate 100% of my investible savings into stocks and shares (equities) or 100% of it into fixed (time) deposits and treasury bills. My investment portfolio allocation changes depending on my own personal assessment of the risk of the markets and it has potentially ranged from 30% equities, 70% money-market or cash equivalents (treasury bills, fixed deposits, cash in bank) to 80% equities and 20% money-market or cash equivalents.

What this means is that even if the stock market corrected sharply, I am somewhat protected in that the 80% of my equities will get negatively affected on paper when I compute the market value of my investments at that point in time. However, because money-market and cash equivalents are less volatile and safer investments, they are relatively protected although their returns are much lower than potential gains from equities through stock price going up or dividends from equities.

Why do you need to understand diversification
If you are serious about understanding and taking charge of your own financial destiny, it is important to learn about different asset classes and to understand the needs for diversification to reduce (but not eliminate) risk. However, many sales people who push unit trusts typically trumpet "diversification" as one of the key advantages of having a basket of shares spread across different industries or sometimes countries and sectors. But diversification while reducing the volatility of your returns from investments also make your investments perform less than it could have.

Diversification vs. Di-worsification
Peter Lynch's book ONE UP ON WALL STREET is a relatively easy book to read for investors who are interested to know about developing their strategies in buying, selling and holding equities with a preference for value investing in companies that have sound fundamentals. Lynch talks about diworsification, where you can diversify until you cancel out all potential gains and also where companies lose focus and try to grow by acquiring businesses that are not complementary to the business strategy of the company.

The downside of diversification is that you are too safe until your returns are abysmal compared to equivalent benchmarks e.g. S&P500 or STI etc. Hence, each of us has to understand that a balance needs to be struck between having different asset classes so that your eggs do not get all smashed when a strong wind blows against the basket versus having different baskets which incur higher overhead costs and charges (e.g unit trusts, mutual funds). So far, most of the investment gurus recommend low cost index funds for long term value investing for those who do not have time or effort to manage their own investments. Unfortunately, there are not many of such products in Singapore.

So what do I do now?
Learn about different asset classes, their potential risks vs returns. Learn about your own risk appetite (or lack of!) and learn about your own investment objectives and returns. Decide on how you want to allocate your investible savings into various asset classes taking into consideration your cashflow needs, your own risk assessments and how aggressive or conservative you want to be in investments.

There is no one correct anwer, each one of you have to find out your own flavour of investing and what type of investment omelette you want to make at the end of your investment horizon.

Be well and prosper.