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?