Quick Lesson: Specialisation VS Diversification

Specialisation VS Diversification. Thats the question most investors, traders, whether new or experience, ask.

Anonymous said...
"hi musicwhiz
if u look at BusinessedTimes diversification of over 10 stocks, one of the portfolio has a 300% gain over 5 yrs..."

I'll like to show everybody the insignificant of that return. "300% over 5 years". If you do your calculations, this is what you'll notice for $1 that you invest in that 10 stocks 5 years ago.

• End of Year 1 - $1.25
• End of Year 2 - $1.56
• End of Year 3 - $1.95
• End of Year 4 - $2.44
• End of Year 5 - $3.05

Impressive. Thats slightly over 300% over that 5 years. OR is it? I used 25%PA for that calculation.

"25% PA"

Thats the kind of returns you get in equity unit trusts with good historical returns (ie. Aberdeen Pacific Equity). When you invest in stocks, you'll want to be looking at better returns wouldn't you? Otherwise why would you be in the stock market? Why don't you just buy unit trusts?

"Whats the use of buying shares and achieving returns attained consistently in Unit Trust? Excitement in shares? Shares are not meant to be exciting. Its for investing."

On the other hand, I'll like to bring to your attention to the powers of compounded returns. It can really make your portfolio look really good. Imagine getting 50%PA on your portfolio in shares. It will look something like this.

• End of Year 1 - $1.50
• End of Year 2 - $2.25
• End of Year 3 - $3.375
• End of Year 4 - $5.06
• End of Year 5 - $7.59

When investors diversify, they are trying to spread their eggs into several baskets. A well diversified portfolio would usually mean 15-20 stocks, but it really depends on the amount of money you have. What diversified investors get is a pretty safe annual return that generally mimic the country's stock index. And thats a very mediocre return.

What unit trusts do is just that. They diversify their funds over large number of companies in their target market. The result is the same. Almost consistant annual return that mimic the country's stock index.

"So why don't you just buy Unit Trusts if you want to diversify?"

For specialisation, investors don't like to spread their eggs. Usually, this kind of investors hold a portfolio of 1-10 stocks. This kind of investors will usually get large returns that can range from 2-5 times the general market movement, but tend to be exposed to a lot of volatility and risks. However, this exposed risk can be managed by several precautions like "cut loss of -7 to 8%", which i preach.

Specialised investors generally know more about their companies they hold. They have more time to do research for their companies, and generally are better informed compared to diversified investors who are probably overwhelmed with information, especially during financial statement season.

Here's my take. If you were to diversify your own assets into many shares, its in my opinion that you should just buy into Unit Trusts. The returns for your diversified shares, compared to returns in Unit Trusts will not vary much.

"Buy into Unit Trusts, if you are looking for safe and well diversified investments."

Do note that when you buy unit trusts, its not necessary for you to buy 10 different unit trusts. Unit trusts are already very very well diversified. I recommend for you to own only 3-4 unit trust, with each targeted to different market.

If you are looking into larger returns in excess of 30% PA or even 50% PA, the route you should take is to specialise. Buy a few stocks, and keep track of those companies like a hawk. Every financial release, every contracts won, every movement in its management (Notice i didn't say keep track of the stock charts).

My recommendation for all is not to over diversify in shares, but to specialise in some. This way, you'll be looking at returns similar to the 2nd example above.