Putting all your eggs in one basket

Though it may sound odd, this scribe would still recommend some investors to put all their eggs in one basket, i.e., invest all your money in one or few stocks rather than diversifying your investment across the market. But what is diversification? U.S. Securities and Exchange Commission (SEC) defines diversification as the practice of spreading money among different investments to reduce risk. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. Thus, the principle of diversification is that one sector or stock may go down, but not all sectors will devalue. For example, when oil price was about 150 dollar a barrel in the last summer, airline stocks were struggling, and now, airline stocks are making money but oil stock are suffering. Can you believe that Harry Markowitz was awarded noble prize in economics in 1990 with William Sharpe and Merton Miller to find out this simple diversification theory, i.e., don't put all your eggs in one basket?(!)

Diversification doesn't guarantee that you will always make money; it just reduces the risk of losing money. However, if you consistently pick winning stocks, you don't need to own many stocks to achieve high returns. Warren Buffett, one of the greatest investors of our time, also doesn't follow conventional wisdom of diversification. In 1996, in a letter to shareholders of Berkshire Hathaway Inc, Buffett says that to invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets. You may, in fact, be better off knowing nothing of these! He said that what an investor needs is the ability to correctly evaluate selected businesses. As an investor, one should simply be able to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher over five, ten and twenty years from now. Over time, that investor will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of that stock. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value. So, even Buffett also do not advise you to diversify your investment across different sectors or the market.

In an optimum portfolio, the greater the number of selections, the less will be the average year-to-year variation in actual versus expected results. Also, the lower will be the expected return since there is a tradeoff between risk and return. In a letter to partners in 1965, Buffett says, "I am willing to concentrate quite heavily in what I believe to be the best investment opportunities recognizing very well that this may cause an occasional very sour year - one somewhat more sour, probably, than if I had diversified more. While this means our results will bounce around more, I think it also means that our long-term margin of superiority should be greater." Even some investment pundits say that the key to diversifying is to not diversify! If you are confident in your analysis, you tend not to worry about price fluctuations. If it goes down, it is just a greater opportunity to buy more of a great business at a great price. Diversifying is for the conventional safety seekers and followers of Wall Street. Though Wall Street claims holding fewer stocks are risky, the results of Buffett prove otherwise.

For instance, take a close look to Warren Buffett's Berkshire Hathaway's investment account: A study about Buffett's trades over the past 25 years find out that his top 5 holdings, on average, have comprised 73 per cent of his portfolio. Another interesting characteristic is that on average his portfolio is composed of only 33 stocks. If Warren Buffett only has 33 stocks in his multi-billion dollar portfolio - how many should an average investor hold? Still a study titled "Imitation is the Sincerest Form of Flattery" proves that from1976 to 2006, the average annual return of Berkshire's stock portfolio outperformed the S&P 500 by 14.65 per cent. Surely Buffet is right when he says: "Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing."

As mentioned earlier, there is a trade off between risk and return, i.e., higher risk leads to higher return on your investment and vice-versa. Diversification leads to you lower risk as well as lower return. For instance, if you buy a portfolio which mimics the DSE 20, it will be hard to beat the market, i.e., your return will be even lower than the DSE 20 because of transaction cost. But if you invest in a portfolio of 5 top stocks from the DSE 20, you will surely beating the market on average. However, other disadvantages of diversifying include the following:

If a stock in the portfolio suddenly performs poorly, it will significantly reduce the performance of the whole portfolio.

Diversifying requires active management and may require frequent buy and sell decisions and incur high transaction costs and thus lower return. Moreover, active management is always time consuming and demands vast knowledge about the market behavior.

Diversification across markets is not always successful especially when other institutions are also trying to liquidate large positions. Think about recent financial turmoil where all the financial institutions are selling off their large chunk of stocks in a particular company, and thus beating down the return from that specific firm.

Another disadvantage is that diversification can be difficult for small investors in the DSE because of limited capital and information.

In Wall Street parlance a, "tenbagger" is a stock in which you've made ten times your money. If you paid 10 taka for a share and selling that share for taka 100 within two years, that share is an example of tenbagger. This term has been borrowed from baseball. In an emerging market like Bangladesh, finding out a tenbagger is lots easier than in a developed market.

However, we need to remember that portfolio focused on a single sector or stock can have some super growth, naturally this comes with increased risk. If you are young, have high risk tolerance and know at least very basic of stock market investment, then go with finding "tenbagger" rather than diversifying. Put all your eggs in one basket. However, if you are about to retire and using your life-time savings to invest in the stock market and happy with a stable return, diversifying is the best option. At the end, the present writer would like to resort to Buffett again: "My mantra has been concentrate to get rich - diversify to stay rich. I may need to reconsider the last part". Find out some "tenbaggers", then put your all eggs in one basket and become the Warren Buffett of Bangladesh.

*This article was published on the daily Financial Express in Bangladesh on February 07, 2009.