Posts Tagged "stock"

Can you Diversify too much?

Posted by Preet on Jul 31, 2007 | 0 comments

This is a tricky topic to talk about.  So please read the caveat at the bottom of this post!

The wealthiest people in the world have, on average, made their fortunes on ONE stock… and that is usually the stock of the company they themselves founded and ran in the form of a small business that just kept expanding.  But of course for every small business that becomes the next GOOGLE, there are countless more that fail and go under. This is the ultimate example of why you won’t get rich quickly by diversifying AND how you could lose everything quickly by NOT diversifying.

Understanding this debate is understanding the trade off that you want to make between risk and reward. You take on an astronomical amount of risk by buying only one company’s stock, but if that company is indeed the next GOOGLE well then it was worth it, wasn’t it? :)

Similarly, a lot of successful investors advocate buying only a handful of stocks (maybe 10-20) that they KNOW and BELIEVE in and expect will grow faster than the rest of the economies in which they are domiciled.  They understand it will be a rockier ride than holding every stock in the world, but expect to be rewarded over the long term for the increased amount of risk they expose themselves to.

By properly diversifying, you virtually guarantee you will never get rich overnight, but you also virtually guarantee you won’t lose your shirt either. Conversely, by under-diversifying you open up the possibility of making a lot money very fast… or losing it!

For new investors – you will want to diversify as much as possible, and across multiple levels of diversification as well – see “What is Diversification?”. (At least until you get your feet wet and experience a full market cycle.)

What is "Diversification"? There is more to it than you might think!

Posted by Preet on Jul 31, 2007 | 0 comments

Diversification basically means not putting all your eggs in one basket. If you hold only one stock and that company went bankrupt, then you would have lost all your money.  If you hold two stocks and one company goes bankrupt you have only lost half your money.  And so on, and so on.

But there is a BIT more to it than just that. If you held two stocks in companies like Sprint and Verizon and someone invents a device that makes phones obsolete, then both companies might go under.  In this case you have diversified by holding two companies, but you picked two companies in the same industry!

Further, if you held two mutual funds that both invested in large Canadian companies (and each fund held 100 stocks), but the Canadian economy as a whole declined, both your funds would lose money.

So there is more to diversification than just holding more than one stock.  The key to proper diversification is to pick different stocks (or other investments) that are NOT CORRELATED to each other. i.e. the values of each do not move in tandem. So when one is up, the other is down, and vice versa. (You still want to pick only investments that are expected to appreciate long-term.)

There are many different way to diversify – something known as “Multi-Level Diversification”. You can diversify by:

1. Holding more than one stock

2. Holding investments from different sectors (Telecom vs Banks vs Mining, etc.)

3. Holding investments in different Asset Classes (Stocks, Bonds, Cash)

4. Holding investments in different Markets (Canada vs US vs China vs Europe, etc.)

…and that is just scratching the surface.

So the take home message is that proper diversification means holding numerous securities that are as uncorrelated to each other as possible, in order to reduce risk. Let’s say that ALL investments in the universe returned 7% over the next 100 years, BUT each had their own “cycle” of when it was up or down in the short term.  If you held only one, then perhaps it made a killing in the first 50 years, but got slaughtered in the second 50 years. And maybe a different one returned 14% one year and 0% the next, and continued to alternate for the next 98 years in a similar fashion, and so on. Imagine that there are 1000 different investments in this universe and each has a very unique pattern of returns, but ultimately returns 7% over the 100 years.  Well if you held them all, you would still get your 7% over 100 years BUT you had a MUCH SMOOTHER RIDE and the variance of any annual return from 7% would be minimal.  Risk is another word for variance – so to reduce variance is to reduce risk – which can be accomplished with proper diversification.

Please note that you can not entirely get rid of risk and that the examples given in this post (as always) are fictitious and intended for educational purposes only.

How do banks make money on Savings Accounts?

Posted by Preet on Jul 25, 2007 | 0 comments

You’ve all seen the adds for the “no fee” savings accounts being offered at various institutions. Have you ever wondered how the banks make money on those accounts? To really simplify it, it is basically as follows: When you deposit your money into a savings account, you agree to be paid interest from the bank, which for the purpose of this post we will say is 4%. Now the bank will take that money and turn around and give it to someone in the form of a mortgage so they can buy a house and charge them 6%. So the bank COLLECTS 6% from mortgage holders and PAYS 4% to savings account holders. The difference between the 6% and the 4% is known as “the spread”.

Of course it is not so cut and dry in that a bank can’t take $1 million in savings accounts deposits and then just go out and give $1 million in mortgages.  What happens when people need to access their savings? The banks have certain ratios they abide to with respect to how much they lend out as a proportion of the deposits they receive.

And of course the more traditional “bricks and mortar” banks also tack on monthly fees to your accounts – which REALLY ADD UP.  Remember: If you are continually amazed by how much profits banks are churning out, you can complain or you can buy their stock! :)