plonkee money an english-er's thoughts on personal finance

November 18, 2008

diversification is terrible if you want to get rich quick

Filed under: investment — Tags: , , — plonkee @ 12:00 pm

Suppose you had £100k to invest, and 10 ideas in which you could choose to invest in. Each of those ideas has an expected return after 5 years. Of course, this is an investment, not all ideas are necessarily successful. Each idea also has an associated probability of working out.

  1. Return = 500% Probability of Success = 33%
  2. Return = 400% Probability of Success = 35%
  3. Return = 600% Probability of Success = 32%
  4. Return = 1000% Probability of Success = 27%
  5. Return = 900% Probability of Success =28%
  6. Return = 800% Probability of Success = 29%
  7. Return = 700% Probability of Success = 31%
  8. Return = 300% Probability of Success = 36%
  9. Return = 1100% Probability of Success = 26%
  10. Return = 1200% Probability of Success = 25%

Now, if you pick the investment with the best return – idea 10 – and invested your £100k into that, then if it works after 5 years you’d make £1.2m. Which is a lot of money.

On the other hand, if you diversify, and invest £10k in each idea, then the most you could get back (if all the ideas were successful) is £750k.

Diversifying dilutes the potential return.

It gets worse, because the although the probability of idea 10 succeeding is only 1 in 4, the probability of all 10 ideas succeeding is 0.00059% (to 5 decimal places). That’s a probability I’d describe as approaching 0.

So, invest all your money in the most lucrative idea and you’ve got a 1 in 4 chance of being a millionaire. Diversify amongst all 10 ideas and there’s an incredibly small chance of it all working and making you richer. But not a millionaire.

so why is diversification sensible?

Well, the key is in the probability of success.

If you invest in all 10 ideas, the probability that none of them will succeed is 3%, the return you’ll get depends on exactly which ideas are successful – it could be anywhere between £30k and £750k and it’s expected to be a little over £200k.

If you invest in only one idea, then no matter which one you pick, more often than not it won’t be the successful one. You might hit it big, but you probably won’t.

Diversification dilutes potential return, but it also dilutes the risk.

applying to real life

If you’re investing in a single company’s shares there’s a small but not negligible risk that it will be the next Enron, or Lehman Brothers, or Northern Rock. There’s a pretty good chance it won’t return the results you were hoping for.

If you diversify and invest in a whole basket of shares the chances that all of them will fail is much, much smaller. Certainly a whole lot smaller than the 3% of my example. And there’s a good chance that one or more companies will exceed expectations and that you’ll benefit as a result. This is why people use investment funds, as they pool everyones money to invest in a whole bunch of different companies.

Diversification is a poor way to get rich quick, but it’s a great tool for sensible investing.

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