Monday, October 6, 2008

Myth of Diversification -> Eggs and Baskets

In last post, I claim that stock market is the backbone of a country's economy.  That post was not very well written as I was trying to combine 3 articles into 1.  There are actually 3 angles or point of views how stock market can be viewed as a country's economy.  If you still don't agree, please let me know, I shall write more on that.  But if you do agree, then let's move on ...
All investment vehicles eventually go to stock market.  Bank invests your money in stock market, gains 12% ( assumption ) and share only 3% back to you in your FD.  Its fair because your 3% is guarantee but his 12% is not.

First bank does a lot of analysis and selects the BEST business in stock market.  Then bank buy its shares and wait.  As the business grows in time, bank shares the benefits.  As time goes, bank has more money too.  There will come a stage bank can no longer buy the shares of the BEST business.  Because bank only wants to lend money to the company, bank DOES NOT WANT TO RUN THAT BUSINESS.  So the maximum shares a bank should buy is 49%.  So what does the bank do then ?

Bank buys the shares of 2nd BEST business in stock market.  So eventually bank would have bought quite a lot of shares of a lot of businesses.  Sometimes thats call diversification or Don't Put All Your Eggs in One Basket.

Similarly in your own finanace planning, you have already filled up the bottom part of your pyramid (previous post: now Finance Planning starts) and you still have extra money.  So you should buy some shares too.  But wait a minute ....
Which is the BEST share you should buy ?
What analysis to perform to find out the BEST share ?
You can check what the bank has bought and you saw a list of stocks that the bank has bought.  You can just buy according to that list and you will earn as much as the bank, Right ?  If you buy the same or similar list, you are also spreading your eggs in different basket, Right ?  You are diversifying your risk ...

WRONG !!  As a matter of fact, ABSOLUTELY WRONG !!

Remember I said stock market is a good example of finance creation ?  Such stable existence MUST come with certain unchangable LAWs.  In short, you MUST follow exactly what the bank has done (the process) !  You can NEVER skip any steps.  And you should NEVER copy result.

How to Buy Stock will come soon but for now, think of it this way.

You have one egg.  Can you put that egg into two different baskets ?  No !  ONE egg can only goes to ONE basket !  And you need to pick which basket to put in.  Only when you have your 2nd egg, then you can consider putting it into the same basket as before or put it in a new basket !

When you start buying stock with limited fund, you should only buy one stock.  And thats better be the BEST one you can ever find !  If you don't know how to find that BEST stock yet, then its not the time to buy yet.  Do you think Bank will simply buy a list of stocks just because another bank buys too ?

Don't Put All Eggs in One Basket

is not the same as

Put your Egg in all baskets

The right way to diversify is :
1. Analyse what you like and what the business does.
2. Pick the BEST one to invest in
3. When you have had enough with #2, then pick the 2nd Best, 3rd, 4th etc ....
4. Revise constantly on this 'Who's BEST' list

In Malaysia, assuming your minimum 0.42% brokerage fee is RM 40,
then ONE EGG is equivalent to RM 10,000