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Some twenty five years ago when I entered the investment world I had a fascinating discussion with my grandmother. She taught me the very important lesson of not putting all your eggs in one basket. This she explained was the key to investment success as it reduced your risk dramatically.
To illustrate the point she explained that she had split her investments equally amongst four banks. All the money was on call or in a fixed deposit depending on the rates payable by the various banks. This spreading of her risk made perfect sense to me. It was only a while later that I came to terms with her error. The error was that she had not spread her risk at all.
Putting your eggs in two baskets is not good enough. You need to put your eggs in a basket and a padded box. The basket may be able to carry more, but the box is safer. If you fall carrying two baskets the dangers are equally great. With a padded box you will be a lot safer but will not be able to carry that many eggs. This is more appropriate spreading of risk.
My grandmother should have diversified away from just having all her money in the bank by putting some into equities, property or fixed interest securities as well. This would have provided effective diversification for her. True diversification requires spreading your assets among investments with different characteristics that will react differently to each other. The biggest challenge in diversification of an investment portfolio is accepting that you will have an underperforming investment within your portfolio. If not you have not diversified properly, you are heading for disaster. A properly diversified portfolio must have an underperforming component to it. Appreciate its benefits.
Investment diversification is appropriately illustrated by the ice cream seller at the waterfront. On warm days visitors form long queues to buy an ice cream from him. To earn extra income and reduce his risk he decides to diversify his business and sell cooldrinks as well. By doing this he increases his income slightly because some patrons buy both an ice-cream and a cool drink and non ice-cream eaters are now buying his drinks. He is now content that he has added another product line to his business. However, this additional product line will not solve his problem on a cold day when people want neither ice-cream nor cooldrinks. usiness risk. Instead of selling cooldrinks he should sell hot chocolate. By doing this he could sell hot chocolate on cold days and ice cream on hot days. This is effective diversification. He will now have a business that will be able to generate him an income every day, all year round.
Not earning any income on cold days is a major business risk. Instead of selling cooldrinks he should sell hot chocolate. By doing this he could sell hot chocolate on cold days and ice cream on hot days. This is effective diversification. He will now have a business that will be able to generate him an income every day, all year round.
If only life was this simple. He does not have limitless cash to ensure that he has sufficient stocks of ice-cream and hot chocolate for most extremes of weather conditions. How can he be one step ahead of the game and keep the right balance of stock? If there were an equal number of warm days to cold days it would be easy for him to spend half his money on ice-cream and the other half on hot chocolate. However this is not always easy. Cape Town weather can be unpredictable at best. He needs to do some planning and obtain information on the average number of hot and cold days per year and buy his stocks accordingly. To be smarter he should get these statistics per season, then per month and act accordingly. If six out of ten days are cold, six out of ten rand should be spent on hot chocolate and only four out of ten rand on ice-cream. This will help achieve the right blend of stock he needs to keep.
Even the best stock management system is not going to cater for “scorchers†and “freezersâ€. On these days he will curse that he had not got more ice-creams or hot chocolate while he is sitting with spare stock of the other product. But in berating himself he remembers that the alternative is just to sell ice-cream or just to sell hot chocolate. By adopting that approach he is going to have days when he could have made more, but also days when he makes absolutely nothing. By blending the two he is getting the best of both worlds although there will be times when he misses out on the jackpot. In the long run he has a better business and will make more money by diversifying effectively, even though at times if he had just stuck to ice-cream or hot chocolate that would have been better for him.
Most of us would have done the same if we were running the business. If this is so self evident why do we not apply this philosophy to our wealth creation strategy? All we need to do is replace hot chocolate and ice-cream with cash and equities.
There are times when you should have had equities on your shelf and there are times when you needed cash. Invariably these times differ and it is exceptionally difficult to determine when those times will be. With “appropriate†research you can do better than just guessing. It makes a great deal more sense however to have a blend between the two. You will miss the peaks but you will also miss the troughs. This balance will reduce your risk and effectively diversify your portfolio for better long-term returns. Remember there will be times that you are not selling ice-creams or not selling hot chocolate. However, you need to have them in stock because we do not know what tomorrow’s weather holds.
Gerrit Viljoen, CFP®
CEO of Ultima Financial Planners (Pty) Ltd
Financial planner of the Year, 2003
012 348 1386
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