Spread it around

By Mary Holm

Monday 24th December 2001

Of all the basic rules about investment, one that few argue with is the idea that diversification is good.

We're told from childhood not to put all our eggs in one basket. And in adulthood most of us know we shouldn't put all our money in property, shares, fixed interest or whatever. It's especially risky to go with just one property or just one share.

Every now and then, though, somebody comes out with a contrary view.

Just last week, in this column, my colleague David McEwen quoted Max Heinrich on the investment strategies of wealthy Swiss.

One of Heinrich's points: "Resist the allure of diversification."

In his book "Rich Dad, Poor Dad", Robert Kiyosaki makes a similar point.

"The main reason that over 90 per cent of the American public struggles financially is because they play not to lose," says Kiyosaki.

They do this by buying a balanced portfolio, he says. "It is a safe and sensible portfolio. But it is not a winning portfolio."

He goes one to say, "If you have little money and you want to be rich, you must first be focused, not balanced... Balanced people go nowhere."

Is he right?

It's true that many really big winners in investment put their eggs in few baskets. The value of a single share can soar far higher than the market as a whole. If you've got lots of money in such a share, you'll be laughing.

But the value of a single share can also go to zero - something that will almost certainly not happen to a portfolio of lots of shares or an investment in a share fund.

Kiyosaki reveals elsewhere in his book that he enjoys taking risks, and has twice failed in business. So his attitude is not surprising.

But the diversify-or-not debate doesn't just hang on your tolerance for risk. It involves the trade-off between risk and return.

As we all know, the higher the expected return on an investment, the riskier it is.

There are two types of risk here. One is that the company will go bust. The other is volatility. Volatile investments are riskier because values might be low when you want to get your money out.

Generally, you can't raise return without also raising risk. And you can't lower risk without also lowering return.

There is an exception to this, though.

The return on a diversified portfolio is, of course, the average of the returns on the individual investments. But the volatility of the portfolio is less than the average volatility of the investments.

That's because when property goes up, shares might be going down. The movements in different assets often cancel one another out.

By diversifying, then, you can lower your risk without lowering your return.

As economist Peter Bernstein says, in "Against the Gods - the Remarkable Story of Risk", "Diversification is a kind of free lunch at which you can combine a group of risky securities with high expected returns into a relatively low-risk portfolio."

Bernstein, whose book hasn't sold nearly as well as Kiyosaki's, but who is much the wiser writer, hasn't got much time for those who shun diversification.

"Occasional large gains seem to sustain the interest of investors and gamblers for longer periods of time than consistent small winnings," he writes.

"That response is typical of investors who look on investing as a game and who fail to diversify; diversification is boring."

But, he adds, a little sniffily, "Well-informed investors diversify because they do not believe that investing is a form of entertainment."

There you have it.

If you enjoy a gamble, don't diversify. But if it's your life savings at stake, you'd be better off to enjoy Bernstein's free lunch.

Mary Holm is a freelance journalist and author of "Investing Made Simple", commissioned by the New Zealand Stock Exchange to write an independent personal investment column. She can be reached at maryh@pl.net. Sorry, but she cannot respond directly to readers.

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