Thursday, October 6, 2011

DIY Share Investing: Prudent Management or False Economy?

Now that you know a bit about us at The Trusted Adviser, it's time to ask you a question - if you are a serious do-it-yourself share investor, why are you going it alone?  For many of you, the answer will be “So I don’t have to pay management fees” or it may be about something more fundamental like trust, or a lack of it, in the advice of others.  Whatever the reason, if you are serious about managing your money (and I am guessing that you are), it is essential that you know how you are tracking compared to the performance of the sharemarket index.  Why?  How else will you know if you are doing a good job?  And if you heed this advice, brace yourself, it could be a very humbling experience.

But investing is not just about return. There is the other small matter of risk to consider.  Now you may not agree with me on this, but I reckon hanging your hat on a handful of stocks is risky
  • It lacks diversification, and
  • It risks significant under-performance compared to the market.

What?  You don’t care if your returns aren’t as good as the market, as long as the return is positive.  If you think that and you’re serious about making money, stop reading now.

For those of you still with me, let’s get back to diversification.

A dozen stocks sounds diversified enough doesn’t it?  And where’s the risk in owning BHP, RIO, the banks, Wesfarmers, Woolies and Woodside?   Shareholders in General Motors thought the same way before the GFC didn’t they? But I hear you saying “GM was having trouble way before the GFC and everyone could see it.  I would never have invested in a stock like that”.  Hhmmmm….Wesfarmers went from $42 to $14 as investors nervously watched them negotiate with their bankers while chewing on a gob-full of debt from the Coles acquisition.  And what about RIO?  $124 to $24 as they carried the can (and debt) from their ambitious acquisition of the aluminium giant, Alcan.

Anyway, enough tripping down memory lane.

Under-performance relative to the market costs real money and that’s ignoring your hours of research.  Wouldn’t it be just a little bit disappointing if you were getting a less-than-market return for all your time and effort?  But I really enjoy it, I hear you protest.

Well if stock picking is one of your hobbies, here’s my advice
  1. Pick a relatively small sum to play with – say no more than 10% of your investment capital 
  2. Take less risk with the rest (check out our post on trying to beat the market - “An investment not worth paying for”).
financial advice
Our main message here is that successful investing is about only taking risks that are likely to compensate you with added return over time.  It is best summed up by our friends at Dimensional when they say: 
Avoidable risks include holding too few securities, betting on countries or industries, following market predictions, and speculating on “information” from rating services.  To all these, diversification is the antidote.”1
For an academic perspective on diversification, you can also view this video:

The Trusted Adviser

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