To diversify or not - that is the question


Hold just a few stocks or spread your investments? The jury is still out

One look at how a bunch of friends approaches the supermarket check-out will tell you that Singaporeans do not like putting all their eggs in one basket.

We all know the drill: The group splits up, each one standing in a different queue. The basket of groceries then goes to the person who gets to the front of the line first.

That eliminates the real risk of everyone being stuck behind the one irritating person who spends a minute digging around for the supermarket's membership card and another three minutes searching for a credit card.

End result: The whole group saves time.

So apparently Singaporeans intuitively understand the concept of diversification, the need to not put all your eggs in one basket. Split up and you ensure you get the fastest queue.

The concept applies equally well in the stock market and is understood by many investors.

This is the time of year when shareholders are reminded about their basket of shares. Mailboxes are clogged with annual reports and invitations to annual general meetings that few have the time to attend.

The need to spread your holdings - diversifying - has long been a mantra in the investing world.

It makes sense when you think about it. Since stocks are considered a relatively risky asset class, it sounds good to spread your risks and avoid putting all your money into one company.

The experts seem to agree.

"With investments, diversifying is key," said the Huffington Post last year.

And the New York Times warned last year that investors "dismiss diversification at your own risk".

"A single-investment strategy is the investing equivalent of going all in on one spin of the behavioural roulette wheel," said the NYT article.

"A well-diversified portfolio is a little bit like what Winston Churchill said about democracy: It's the worst form of investing except for all the others."

I was also a big supporter of diversification, believing that our risks would be reduced if we had shares from more companies in our portfolio.

And it is easy to do that in Singapore. You can buy one lot of stock for $1,000 or less, so it is conceivable that you can hold a large basket of companies, but very few shares in each, for a reasonable outlay.

But while diversification may be the common financial wisdom among most commentators, it seems that not everyone is on message.

A book published in 2009 by Dr Michael Leong, founder of investment portal ShareInvestor, speaks out against diversification, or excessive diversification.

"For all my long-term investments, I only have about five stocks," says Dr Leong in Your First Million: Making It In Stocks. "If I diversify too much, even if a stock rises 100 per cent, it may not increase the worth of my portfolio significantly."

Investors feel good when one stock rises strongly but their portfolio value does not increase by much if they have spread their investments too thin.

"My aim in investing is to multiply my net worth and not to feel good," he says. "If I want to feel good, I will drink my gin and tonic."

Dr Leong quotes investment guru Warren Buffett, who once said that "wide diversification is only required when investors do not understand what they are doing".

This message was drummed in when a colleague lamented that he has diversified too much.

"If only I had stuck to my father's style of investing, I would be a rich man," he said.

"He only holds three counters - BAT, UOB and Sime Darby. Only Sime has underperformed, the other two's performances were astronomical.

"Even if I started buying when I commenced working, I would have made a big pile."

United Overseas Bank (UOB) share price has increased eightfold since the mid-1980s, as has the stock of BAT once capital changes like bonus issues are factored in. This is British American Tobacco Malaysia, formerly known as Rothmans, the Kuala Lumpur-listed cigarette maker.

And to be fair Malaysian conglomerate Kumpulan Sime Darby has not done too badly, just not as well as the other two.

Its share price in 2007 - before a merger with two other firms - was about four times the value in the late 1980s. The share price of the combined entity, Kuala Lumpur-listed Sime Darby, has dropped since then.

Of course, if you are going to invest your cash in only a few companies, you had better be very sure that you are backing the right horses.

Dr Leong says as much. An investor must first be a master of fundamental investing - the science and the art of studying a company's business prospects and financial figures - before going in, he argues.

Especially important is the concept of "margin of safety", or buying shares only if they are below their intrinsic values.

"Otherwise, focused investing can be a recipe for disaster."

Dr Leong says he watches his stocks like a hawk, tracking their company announcements and understanding their industries.

"But you can devote such an intense focus to only a handful of stocks without wearing yourself out."

Many investors may do their research before investing but stop the monitoring once they have bought the stock, especially if they have a lot of counters and do not have the time to track all of them.

The temptation is to assume that a strong-performing company will continue to do well.

But investors with a small portfolio will find it easier to monitor share developments and adjust their portfolio accordingly.

If you still believe in diversification, it may be a good idea to buy a unit trust or a low-cost index fund known as an exchange-traded fund.

Trying to build up a large portfolio with a small amount of money will naturally mean buying only a small number of shares in each counter.

The only person to be happy will be your broker as you cough up lots of money in fees for all your trades.

Best to go with a pre-packaged fund, I say.

But overall, is it a good idea to diversify?

While most financial writers say "yes", the answer is actually not so clear-cut and the jury is still out.

Having said that, you and I can probably agree that it is still a good idea to "diversify" when it comes to supermarket queues.