Friday, January 26, 2007

Eggs and basket: How do you distribute the eggs?

Conventional business schools wisdom states risk can be reined by diversifying your funds. Most business schools just simply reward difficult and complex behavior more than simple behavior, in all cases, simple behavior and idea are superior to complex ones. The saying "never put all eggs in one basket" is an advice I strongly disagree with. In stating this opinion of risk in relation to diversification, the definition of risk, using dictionary terms, is "the possibility of loss or injury."
So what causes loss and injury? The main cause behind it is not having a lot of baskets. Rather it is to know what you are doing and how well you understand the basket. The only reason why you can no longer put more eggs in a basket is when the basket is filled to the brim.
For example, let's say there’re 3 baskets, all with different strength and make of different material. One is made of steel, one with rattan, and one with paper. Each basket has a similar volume capacity which can accommodate 30 eggs each. If you have 30 eggs, which basket would you put in? Raise your hands if you will put everything in the one made of steel. Raise your hands if you will put some in steel, some in rattan. Obviously, you know what the answer will be. I rest my case if all of you will put your eggs in the steel basket. If any of you will put 25 eggs in steel, 5 eggs in some other basket. I would be much interested to know the reason behind your decision.
Now, if you have 40 eggs, which basket would you chose and how many eggs will go into each basket which you chose? For me, I will put 30 eggs in the steel one and 10 eggs in the rattan basket. Again, it is a no-brainer.
If you use this same concept and apply it to life or investment, most of you will be able to get a better result in everything you do.
Unless the person who is making a decision on how many eggs go into which basket do not have an idea on the nature of the material of the basket, then he or she will have a problem of how many eggs will go into which basket. So if he does not know the kind of material of the basket, the logical decision will be to place 10 eggs in each of the 3 baskets. Then when the bottom of the paper basket gives way first, he will know the impact of his decision.
When you think further, this example of eggs distribution is similar to what Warren says for investment, firstly, to protect your principle. To achieve this objective, you must know what you are doing and to do it well, diversification is not a method that will assist the process of doing well. It just shows that diversification is for people who don't know what they are doing.
So if you know what you are doing, it makes no sense to diversify. Diversification only serves as a protection against ignorance. But if you are ignorant, isn't it better to stay out of investment altogether rather than to risk your principle? And even if you want to invest by diversification, it just simply means you are just trying to play safe to ensure that nothing bad will happen to you relative to how the market performs. So you can still be losing when the market goes downhill. It is just relative measurement to the general investors’ results that you are not the odd one out. There's nothing wrong with that. It's a perfectly sound approach for anyone who doesn't know what to do but it just isn't a good reason to do anything if you do not put in some effort towards understanding the nature of what something can do for you.
So if you have capital which is too little to buy up the business which you want to own - think in terms of the eggs distribution example - it is crazy to diversify the capital into a few businesses. It just lowers your returns. If you have 10 eggs to put into any of the 3 baskets again, it is crazy to put 7 in the steel and 3 in the rattan or paper one.
Clearly, by putting all the 10 eggs in the steel basket, it ties up with Warren's advice of "Risk can be greatly reduced by concentrating in only a few holdings."
Anyway, I hope the eggs and baskets example cast some light in to the much twisted conventional thinking on risk can be reduced by diversification. Yes, it can be but only if you do not know what you are facing with. If you have an idea of what you are doing, why chose an option with the strength of rattan over an option which is much stronger with the strength of steel?


Anonymous said...

Hi Berkshire,

Long time! And happy CNY! Hope all is well. Interesting post on diversification. Wow, you just eradicated modern porfolio theory in one post! Hehe.

I think it make sense to diversify for most people, but not for Buffett. This is bcos most pple cannot figure what's the basket made of.

This is the crazy thing about companies. You cannot say for sure that this company can do well for all eternity. Going back to the basket analogy, it means that the basket may be made of steel today, but somehow tomorrow it may become paper. Look at Osim!

But for Warren Buffett, it's different. He knows for sure the basket won't change. Bcos of his talent, experience, network, due diligence etc, he can sniff out good companies, invest and know with close to 100% certainty that the company will deliver.

For the rest of us, it's never for sure. Hence it may be better to diversify. Peter Lynch holds a 1000 stocks in his Magellan Fund, I think.

But I think this debate may see no right answer. It comes back to style perhaps. And also whether it is actually feasible. Imagine if you have only $10k to start with, how to diversify? Can't even buy 1 lot of UOB...


fishman said...

Hi Bershire,

great post! Once again thought provoking insight for me.

I've known of diversification for awhile, but never have I stop to think beyond the why of diversification.

Diversification is such a common starting point that all financial advisors like to start off with. And I've met with so many advisors before.

For me, diversification really makes sense considering that, like what 8% brought up, small investors like us are so short of resources. Also we need knowledge to determine strength of the basket, but don't want to miss the boat at the same time.

So when I first started wading into investment, diversification is one of the key principles that I decided upon.

And that's why I started off with unit trust. To slowly build up the size of my egg and also to give me some time to build up knowledge.

Berkshire said...

Hi 8PA and Fishman,

First of all, a very happy CNY to both of you and hopefully a good year ahead.

As to having a small sum of principle, say $10K, it makes absolutely zero sense to diversify, irregardless if the amount can buy you a very "expensive" stock or a penny stock. Anyway, the price of the stock is nothing if one cannot tell the value of it. The ticker can show the price to be $20 per share but what is the value of it can generate? On the other hand, it is the same for a penny stock. Irregardless of what kind of stock it is, most important thing is the value it can give in relation to the price that you pay.

Back to the topic of having a small sum to invest. If you have $10K, as what 8PA stated, it makes no sense to buy 2 or 3 different stocks. Why? Because for every trade you make, it cost you roughly a minimum of $28 per trade, i.e if you buy and then sell for a profit, it eats up $56 for commission. So it you split the $10K into 3 stocks, you will pay a total of $168 alone on commission, which is equal to 1.68% on your initial principle. Similarly, if you divest into 2 stocks, it you will pay about $112 on commission, equal to 1.12%.

So how does this works out for an average investor who is looking for say 8% return, you got to ensure you get a gross return of 9.68% into order to take home a net return of 8%. Not a tough job if you are able to tell roughly the make of the basket, but for the general investor, it is a very tough job to do for the long haul, although in a bull market, any Tom, Dick, or Harry can do that with ease provided they can curb their emotions to get out at the right time before the party ends.

And yes, 8PA, for the general investors, I agree they will do so much better by diversifying since they cannot tell what the basket is make of. Why? Because in my opinion, most do not put in much effort, or rather, they are looking at things in the wrong direction. When the idea is located in the South, and you have people looking in the North, there is zero percentage they can ever tell what the basket will be made of, isn't it?

Osim is just one business in my opinion that did wrong because of one of their acquisition...perhaps they paid a high price for their North America venture. But in any case, I personally do not really fancy their business because I cannot understand what competitive edge they have. Ron may be a good manager but in life, you cannot transform an average business great just because you have a great manager.

And there are some businesses which can turn gradually from Steel to ratten to paper in the end. For example, the newsprint business which used to have a bulletproof edge, and General Motors. For the newspapers biz, what multiple should you pay if the biz is earning $100M a year with earnings declining 5% per year, compared to another biz earning $100M per year with earnings increasing 5% per year? Don't look at what the tickers tell you, it wastes your time, think about it. There's always a percetion lag in most things until the bottom gives way.

Also, i agree you cannot say for sure that any business in this whole wide world can do well for all eternity. In Mungers' words, "It'll be a rare business that doesn't have a way worst future than a past." Keeping this in mind, the goal in investing is to enhance your chance of winning, and to do so, it is all about how well you can read a business and its certainty. I remember a couple of weeks back, an Executive from General Motors commented something in the line, "If we are going to commit a plant, we like certainties so that we can calculate our returns." Similarly, in investing, that is what any investor should do.

webctm said...

I totally agree with Berkshire. You have to do your studies and concentrate only on a few stock. I simply cannot think of any successful investor who believes in diversification. Peter Lynch may hold more than 1000 stocks in his fund but I believe 50% of the investment is on maybe 100 counters and the rest spread over the other 900 counters. If he spreads 100% equally over the 1000 counters, I dont think he can make the kind of returns that he is making.


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