How to stay safe when doing-it-yourself

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The return on your portfolio is the aggregate of the returns on individual securities: the risk on your portfolio is not the aggregate of the risk of individual securities. With the aid of diversification you can earn more return with less risk.

The first share I bought was in a small shipyard called Robb Caledon. The purchase was both a rewarding investment and a rewarding lesson in investment.

Robb Caledon was bankrupt. But it was 1976, and a bill to nationalise British shipbuilding was going through parliament. If the bill became law, the assets and liabilities would be assumed by the government and the shareholders would receive around 100p a share. If the bill failed, the shares were worthless. The market price was 40p.

It was an example of the first principle of intelligent investment: always think of your assets and liabilities as a whole. You cannot measure the riskiness of your overall investment portfolio by adding up the risk of each individual element of it.

Robb Caledon was an interesting investment because it was a hedge. The most likely scenario in which the nationalisation bill failed to pass was that the weak Labour government collapsed. In that case, the market would have reacted with relief, and the prices of other shares would have gained substantially.

So, adding a small stake in Robb Caledon to any portfolio reduced, rather than maximised, its overall risk. This was true even though, taken on its own, it was an extremely speculative purchase.

Assets don’t have to be hedges to reduce risk. It is sufficient that individual risks are not perfectly correlated with each other.

For example, if you bet £1 on a single toss of a coin, you win £1 or zero. If you bet 50p on each of two different throws, you win 50p half the time. If you bet 1p on each of 100 throws, what you will win will be very close to 50p. This is the power of diversification. A small fraction of a large number of independent risks is much more certain than the outcome of any of the risks taken separately.

The fundamental insight behind diversification is the simple mathematical idea that the return on a portfolio is the sum of the returns on its individual components – but the risk of the portfolio is not. A risk-averse individual can therefore build a low-risk portfolio from a collection of risky assets if the assets are appropriately selected.

Hedges, such as Robb Caledon, are the most effective diversifiers. But there can be substantial gains from combining unrelated risks, and significant gains from combining risks that are less than perfectly correlated.

An emphasis on diversification implies a different approach to stock selection. Almost everyone who thinks about investment opportunities begins by asking ‘what is likely to go up?’ But the construction of a diversified portfolio requires as much attention to correlation as expected return.

Such an approach means rejecting tempting investments because the returns from them have similar characteristics to investments you already hold. This will happen often, because what made the earlier purchase seem attractive may also apply to the new one.

A portfolio indexed to the FTSE 100 or All-Share index contains a lot of shares, but that is not the same as diversification. A small number of securities provides substantial diversification if the returns are unrelated: a large number does not if the returns are closely related.

An indexed portfolio includes a heavy representation of large businesses that sell mainly to the advanced economies of the US and western Europe. Their fortunes wax and wane together with the world economy. An indexed portfolio also reflects the weight of opinion in the market rather than the underlying economic importance of different activities.

A private investor should focus on fundamental characteristics in weighting different sectors, which all have their own cycles that are not necessarily in sync with the economic cycle.

Diversify internationally. Look to Japan or Russia or Taiwan, but remember that real diversification comes from companies orientated to their domestic economies, rather than businesses with which you are more familiar. There is no point in reducing your holding in Glaxo in order to increase your holding in Pfizer.

Over the medium and long term, returns from small companies – whose futures depend on idiosyncratic factors – will generally be less related to each other than large company performance.

The return on your portfolio is the aggregate of the returns on individual securities: the risk on your portfolio is not the aggregate of the risk of individual securities. With the aid of diversification you can earn more return with less risk.

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