Diversification

[DesertCat]

I went hiking today and spent a lot of time thinking about this and how much risk you want to take when you are young (i.e. 25) and older, as well as how much you wnat to take with a large portfolio vs. a small one. There are actually some interesting implications to this conundrum. I need to do some calculations but hopefully I'll post something worth discussing later...

[Sniper]

When you are young, you can afford to take larger risks, if in exchange you are getting the opportunity for larger returns... and you have a consistant stream of income.

If you are young and your port is small, again you can take larger risks, because theoretically, the value can be easily replaced.

Diversification, can be as simple as 5 seperate stocks. The main point of diversification is that no single event should be able to wipe you out. As I think Ed pointed out, you wouldn't take your whole poker bankroll and sit down with it at a NL table (that would be an unacceptably large risk), or place it all on black [img]/images/graemlins/smile.gif[/img]

As you get older and your port gets larger, you can still take some wild risks, but you should only do so with a portion of your portfolio. Some of the experts recommend that you take 10% of your port and use it to make riskier "bets" than your normal risk tolerance for the remainder of your port. If you are successful, the extra risk can have a substantial impact on your total return, while if you are wrong, the total impact of the risk is relatively small.

[DesertCat]

I was thinking about whether it's worthwhile for younger investors to take more risk for a higher reward. I posed the question, what if you could invest 100% of your portfolio in one of two investments each year. Investment One is the "high risk" investment, 45% of the time it was worth zero at the end of the year, but 55% of time it would double at the end of the year.

Your other option is the "no risk" investment. 100% of the time it's worth 10% more at the end of the year. You are 25 years old and saving 50k per year, and want to retire wealthy, which you believe will require $5M.

On the surface, the EV of both should be the same, +10% per year. But the high risk option offers much more upside, at the risk of having to start over every so often. Let's also assume you are 25 years old when you start.

If you only choose the no risk option, I estimate you'll have $5M about age 50. The high risk option can get you there in a little over 6 years (age 31). But only does this once in thirty six times. Presuming you switch to the conservative approach after busting, 97% of the time you'll have to work an extra one to six years until retirement.

I looked at taking shorter periods of risk, then switching to the no risk investment. For example, if you only tried the high risk option for three years, one sixth of the time you'd make $550k by the third year and retire by age 46.5. But the rest of the time you'll be working an extra two or three years. Two years of high risk only allows you to retire at age 48 a little less than one third of the time, while adding two more years of work the majority of the time.

These are all assuming I did the math right. And I don't pretend to say my super simplified scenario closely approximates the index funds vs. putting it all into one investment risks/rewards.

But I just couldn't find a scenario where I felt that taking the risk was clearly the better option. And I think it's because of one important factor, the relative utility of having more money. Having $2M doesn't normally make you twice as happy as having $1M. The relative utility of every increasing dollar you accumulate is less than the previous.

In fact, just having a significant amount of cash in the bank has tremendous value. It provides you with more opportunities. More investment opportunities (i.e. buying a business for example). It gives you more freedom, the ability to work at jobs you like over jobs you need, for example. Going back to zero has significant opportunities costs. You'd hate for it to happen just before finding the one great investment opportunity of your life. Having money provides so many options it would be miserable to go back to ground zero after you've accumulated a reasonable amount.

Or maybe I'm just getting cranky and conservative in my old age

[AceHigh]

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On the surface, the EV of both should be the same, +10% per year.

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But shouldn't we assume there will be a payoff for taking the risk, and so the higher return/EV? The lower risk option should be more attractive if the EV's are the same.

[DesertCat]

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On the surface, the EV of both should be the same, +10% per year.

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But shouldn't we assume there will be a payoff for taking the risk, and so the higher return/EV? The lower risk option should be more attractive if the EV's are the same.

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Now you are talking Efficient Market Mantra (greater volatility being associated with higher returns), which I don't believe in. Turn it around, if you could invested your one thousandth of your portfolio at a time in these opportunities. You'd end up with similar returns no matter whether you put your portfolio in one thousand "no risk" opportunities vs. one thousand "high risk" opportunities. Essentially over many iterations, they are offering the same "risk adjusted" return.

[AceHigh]

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On the surface, the EV of both should be the same, +10% per year.

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But shouldn't we assume there will be a payoff for taking the risk, and so the higher return/EV? The lower risk option should be more attractive if the EV's are the same.

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Now you are talking Efficient Market Mantra (greater volatility being associated with higher returns), which I don't believe in. Turn it around, if you could invested your one thousandth of your portfolio at a time in these opportunities. You'd end up with similar returns no matter whether you put your portfolio in one thousand "no risk" opportunities vs. one thousand "high risk" opportunities. Essentially over many iterations, they are offering the same "risk adjusted" return.

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Well, think of it this way, if we are only buying one stock from our list of top stocks, our lock of the year or whatever we want to call it, shouldn't it outperform our own picks of top 10 or top 25 stocks?

We don't expect all of our picks to perform equally do we?

[Degen]

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Put 20% in bonds, the rest in 5-10 stocks and experience the magic of compounding.

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Also known as 'diversification'

Other than you saying that my strategy 'isn't smart' do you have any other thoughts to add on why?

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is no such thing as a sure thing, you are simply not getting the return that justifies the risk.


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I had it all in GOOG for several months and more than doubled up (with margin). What was my risk there? Not much with my stop-loss usage...

In the case of a business...there may be a lot more risk than with a stock, same with real estate...but there is very little risk of ruin (or even profit ruin) if I do it smart...IMO.

This is all assuming smart investments...a big assumption.


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Are you implying that if you invest in more than 1 venture, say two stocks, than that is 'diversification' ?
Surely not.

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No. Just that another great investment might present itself before I have decided to exit the first.

[Degen]

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My strategy up to this point has been to put all of my investment money in one or two investments that I think are excellent. Whether this be a hot stock or a piece of real estate or a business or whatever. I've been taking my whole pile and shoving it behind ventures I see as outstanding.

I'm 25 and a professional poker player...I embrace calculated risk taking.


This article reinforces my position:

Recently in the Portfolio thread somebody suggested this was poor.


Anybody care to weigh in on either side of this?

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Well, you are a pro poker player. Do you embrace playing for your entire bankroll at a single game, no matter how fishy you think it is? Why would you manage your portfolio less expertly than you handle your bankroll?

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The risk of going bust at a NL table is a bit different than in an investment. It happens probably over 10% of the time with the poker example...

Great responses all around, nice little forum we got here...

Now to find me next wonderkid...(maybe with 25% of my fund this time [img]/images/graemlins/grin.gif[/img] )

[lastsamurai]

Let me ask you a few questions...
1. How much are you investing?
2. Are you investing in stocks?

William Oneil saids even if you have 100K in the market dont over diversify your portfolio...Find 4-5 good investments to buy and cut your loses. General rule is 8%. With the extra cash you could build more posistions in your other winners... Go buy "how to make money in stocks" and read the section on when to sell. It's one of the best books to read out there.

[Degen]

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William Oneil

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How do you think I found Goog? It's been atop or near the top of the IBD hot picks for so long...

$ amounts I don't find relevant to this discussion...I invest in anything I think can make money [img]/images/graemlins/smile.gif[/img] Right now I'm going head first into a business venture that I am now rethinking my personal financial commitment to...don't wanna become an example in a thread like this a couple years from now...