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diversification is terrible if you want to get rich quick

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.

housekeeping

Just a quick note that I’ve altered the look of the site a little with a new theme and logo (from logos for websites) - if you normally read in a feedreader you might want to head over and check it out.

If there are any features that you’d like to see on plonkee money, now is a good time to let me know. I’m toying with the idea of adding something so that you can email a post to a friend.

foolproof money making scam

I’ve remembered a foolproof money making scheme scam.

Pick a stock, any stock.

Write a short investment article stating that the stock will increase in value over the next week.

Write a short invesment article stating that the stock will decrease in value over the next week.

Send each investment article to at least 1024 people, keeping a track of who received which article.

One week later, check what happened to your stock. Keep hold of the list of people who received the correct article.

Pick a stock, any stock.

Point out the correctness of your previous stock tip and write a short investment article stating that the new stock will increase in value over the next week.

Point out the correctness of your previous stock tip and write a short investment article stating that the new stock will increase in value over the next week.

Send each investment article to half the people on your previous list, keeping a track of who received which article.

One week later, check what happened to your stock. Keep hold of the list of people who received the correct article.

Repeat a further 8 times (so that you have sent out 10 sets of stock picks).

There will be at least remaining person who has received 10 good stock tips in a row. Offer them the opportunity to buy your stock picking system for a very reasonable price

Make up a stock picking system.

Sell it to them.

The beauty of the scheme is that it’s really hard for people to disbelieve you. For the one remaining person, you were right 10 times in a row. Why on earth wouldn’t you be right in the future? The fact that you were right by chance will probably escape them entirely, because they won’t know about the other, wrong, stock picks.

The way to really make it make money is to start with say just over 100,000 people. Then you’ll have around 100 people left at the end and you can probably several of them to buy your stock picking system. And make your stockpicking system an auto-subscribe thing. People always forget to cancel subscriptions.

By the way, I’m not sure whether or not the scheme that I’ve described is legal. It certainly isn’t ethical. But it’s something to bear in mind when you read great stock tips. It came into my mind when I received an unsolicited email about a stock, followed up a couple of days later by an email telling me that the stock tip had been right and giving another tip. I think I marked them as spam and moved on. I’m much more into sensible investing than unsolicited stock tips.

If investing in individual shares is the way you prefer to invest - and it can be sensible if you diversify well - then do your own research. If you can’t independently say why you think something is a good investment, then it’s not a good investment for you.