|Topic||Trying to Get My Concepts Right|
I view this board regularly but post rarely. ;-)
I have a problem with diversification. Eliminating non-systematic risk, thereby obtaining the same level of return for lower risk. I understand the theory of it.
Now for REAL LIFE. Diversification basically means mediocre returns. Why not just invest in the stock you believe in? That is what I'm doing in REAL LIFE. Plunger?:-)
I cannot seem to justify investing my savings into a bunch of stocks just to diversify my portfolio. So I think I do not truely understand diversification and consequently CAPM and SML.%-)
Is there anyone who feels the same way? Or is there anyone who understands the concept enough to explain it better?
|You seem to understand the concept. What you are not taking into account is your risk level. Obviously you are prepared to tolerate a higher level of risk which means you will not neccassarily be fully diversified.|
|IF YOU EVER PUT ALL OF YOUR MONEY IN ONE STOCK ANF YOU KEEP DOING THAT THERE IS ABOUT A 99% CHANCE THAT YOU GONNA END UP HAVING LESS THAN YOU STARTED.
MANY PEOPLE HAVE THE EGO AND THINK THERE ARE RIGHT NOMATER WHAT THEY DO IN THEIR LIFES AND THEY END UP DOING THE SAME IN THE STOCK MARKET.
THE RESULT IS BIG LOSSES.
1. WHAT MAKES YOU BELIEVE THAT YOUT GONNA BE RIGHT PICKING YOUR FAVORITE STOCK?
2. WHAT MAKES YOU BELIEVE THAT YOU HAVE BETTER INFORMATION THAN OTHER PEOPLE IN THE MARKET THAT THEY DO THIS FOR A LIVING?
3. WHAT MAKES YOU BELIEVE THAT EVEN IF YOU HAVE THIS INFORMATION YPU GONNA END UP PAYING THE RIGHT PRICE?
4. WHAT MAKES YOU BELIVE THAT THE OTHER PERSON WHO IS GONNA SELL YOU THE STOCK AT A SPECIFIC PRICE IS SO STUPID TO GIVE AWAY A BARGAIN.
IF YOU DO THAT ONLY LUCK CAN SAVE YOU.
YOU MIGHT BE RIGHT ONCE MAYBE TWICE AND MAKE ABOVE AVERAGE MARKET RETURNS BUT WITH 100% CONFIDENCE THE MISTAKES YOU GONNA DO THEY WILL HAVE MORE IMPACT.
NOBODY EVER WAS RIGHT ALL THE TIME PICKING ONLY ONE INVESTMENT.PERIOD.
ACTUALLY MOST OF THE PEOPLE THEY CANNOT MAKE ABOVE AVERAGE MARKET RETURNS. VERY VERY FEW END UP MAKING THE BIG BUCKS.
AND i AM NOT TALKING INVESTING $1400 IN ONE STOCK AND MAKING $3000....THAT'S GAMBLING
i AM TALKING TO PUT ALL YOUR SAVING A SIGNIFICANT AMOUNT OF MONEY IN ONE INVESTMENT AND KEEP DOING IT.
IF I HAD TO MAKE ONE BET FOR ALL OF MY MONEY I WOULD DO THE FOLLOWING:
I WOULD BET THAT BUY DOING WHAT YOU SAID YOU GONNA END UP LOSING TONS OF MONEY IN THE LONG RUN.
bY DIVERSIFYING YOU DON'T NEED TO HOLD EVERY POSSIBLE CRAP...JUST IF YOU LIKE STOCKS PICK 10-20 OF THEM SO AT LEAST YOU GONNA LAST A LITTLE BIT MORE.
GOODK LUCK .....AND HOPE FOR THE SOCIAL SECURITY TO SAVE YOU.
You seem to imply that diversificatin is putting money in more than one stock which means all money in equity market. But diversification is not limited to assets within equity market. You have to consider all asset classes which include debt market, real estate, assets in other countries. Only than your non-systematic risk is 0. In present situation, if you put money only in debt market and equity market, your losses in equity market will be off-set by gains in debt market. so your losses will be less than the losses by investing only in equity market.
Also, diversification will not save you if you invest in bad assets even if theoretically your non-systematic risk is 0. Valuing assets to see if the current price is less than its value is must. Just diversification will not substitute necessity to evaluate the asset.
Hope I am clear.
|The idea of maximum diversification is based on the efficent market theory and the CAPM. It may not be the way to go if you don't believe in efficiency and CAPM. Few have called Warren Buffett stupid for having nearly all his money in BRKA.
Then again if you are speculating then some diversification is a good idea - I think in Berkshire's portfolio Buffett never went above 40% in one stock. And if you don't have special knowledge index funds beat most active money.
Although even then there is the question of which index. Jeremy Grantham writes interestingly on that stuff (not useful for the CFA but good real world info).