To concentrate or to diversify?

On driving through the Italian countryside… “There’s no need to drive fast.  It just increases the percentage of risk.  I am not being paid and there is no incentive or reward.  So why would I drive fast?”
– Niki Lauda, Austrian former Formula One driver and three time world champion, from the 2013 movie, ‘Rush’

 

Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

 

Although concentrating your money into one or a small number of investments can make you rich, does it ever make sense to be “all in”?   You can become rich by saving enough and making wise diversified investments.  It may take more time, but you have the highest probability of getting there!

Many years ago, I thought I could become wealthy through making a single large investment.  I learned very early about a new patented technology called, Wideband Orthogonal Frequency Division Multiplexing, or W-OFDM.  This is a modulation technique that became the technology for 802.11g and 802.11n wireless standards for low cost, high-speed Wi-Fi products.  The company had sued several large companies for patent infringement, including Cisco.  The speculation was that Cisco might try to buy them out or come to a licensing deal.  Some analyst reports had price targets on the company with a potential five-fold increase in share price.  I also had several friends that were computer technical people who were familiar with the technology who also made investments in the same company.

Although the company ultimately got most technology companies that rely on the wireless standards to license its technology, including Cisco, the licenses were at such low rates that the hoped for company share price never materialized.  Instead, my shares were diluted as the company went through many rounds of equity financing as they regularly ran out of money.  To make matters worse, the developers of the technology who controlled the company were not the best managers.  My investment eventually became practically worthless.

I made a concentrated investment thinking I might become rich.  In essence, I did not fully appreciate all of the risks – a small company that is not financially strong enough to be able to defend its patents through having enough resources to last years through trial.  Companies like Cisco simply ran roughshod over the patents building their routers and other products with impunity.

The reality is that any investment, regardless of its prospects, simply might not work out.  There are no guarantees in life.  Human behaviour is another unpredictable factor that can make even a high probable investment return into a short-term loser where people choose to sell an investment to low prices compared to its true intrinsic value.

For this reason, I am a strong proponent of not making concentrated investment bets.

But this is not the end of the story.  I seek to own different types of profitable businesses that sell different types of products or services.  (To help with this, I try to diversify my stock investments across several industry sectors).  This is based on the idea that these different types of businesses don’t move up and down in perfect synchrony.  As a result, a portfolio of different types of businesses will have less risk than the weighted average risk of each individual investment, and often less risk than the least risky of its constituents.

It goes without saying that in selecting different businesses to own, it is important that each such different business are all attractive stocks of profitable businesses that can be acquired at a good price; otherwise we ‘diworsify’ the portfolio.

So let us never forget:

  1. don’t risk your life by concentrating your portfolio, and
  2. your portfolio should consist of profitable blue-chip income producing quality businesses that sell different types of products or services.

If you are going to take risks, bet on yourself through education and career training where your talents and interests lay where you’re able to make a good living.  If you’re going to concentrate your life savings, it better be where you control the business, that you have years of experience in such a business, and that you have all of the qualifications you require.

Steve Nyvik

Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P. WHAT I DO: Steve builds, from blue-chip dividend paying stocks and bonds, a tax efficient 'pension' designed to meet your needs through time without taking unnecessary risk. Financial planning advice and service are included to make sure that if ‘life happens to you’, your goals aren’t derailed in the process. Phone: (604) 288-2083 (extension 2) Toll Free: 1 (855) 855-9267 (extension 2) Email: Steve@lycosasset.com