Sunday, February 27, 2011

Volume 3 Issue 8: Intelligent Investing

The Power of Diversification?

Very often, we hear so-called financial planners tell us to diversify our assets to minimize risks. Today, we shall examine a few simple cases to put this adage to the test. Let's just assume that Mr UTA (Unit Trust Agent) is a relatively educated investor and has decided to listen to his "financial planner" to diversify his assets when investing in the KLCI. So, what better way than to diversify it according to the KL Composite Index itself.

For your information the KLCI comprises 30 of the largest stocks by market capitalization listed in Bursa Malaysia. By that virtue, how badly can Mr UTA do?

Now let us take a look at the KLCI since January 2003.

If Mr UTA were to buy and hold all the stocks according to the KLCI since January 2003, he would have earned a handsome return of 124.0% in total or about 10.4% per annum. That is not too bad by any standards. But in actual fact, Jan 2003 is at one of the low points of the KLCI. We will come back to this later.

Now let us take a look at the performance of Bhd (DIGI) in the same time period. 

The returns for DIGI, excluding dividends paid, is 1,029.5%, or a whopping 35.0% per annum. Now, this is one case where one particular stock has outperformed the KLCI. The reason I picked DIGI was because it is a household name that many of us can relate to. Most people would have known or heard about what DIGI was about. It is not some obscure stock that is into some sketchy business. The key was in finding out the fact DIGI was a good investment all the way back in 2003.

Let us look at another household name, Parkson Holdings Bhd (PARKSON).

OK, so PARKSON is not DIGI. DIGI may have been an exceptional case. The cumulative returns for PARKSON over the same time period was about 347.0% or an annual compounded rate of return of 20.4%. Both of these stocks clearly outperformed the super diversified KLCI by a huge margin.

Perhaps you may think that stock picking is luck. What we hope to do here at the Main Streeter is to identify stocks like DIGI or PARKSON way in advance and buy them at times such as in 2003 when they were severely undervalued. While there is some element of probability in this, but it is most definitely not luck.

Finally, let us look at the KLCI again. But this time, assume that Mr UTA had bought into the KLCI since January 1994.

After approximately 17 years and 2 months, the overall return for Mr UTA would have been ONLY 16.8%, which translates to about 0.91% compounded per annum. Yes, it is less than 1% per year. Mr UTA would have been so much better off if he had just did nothing but put his money into fixed deposit.

As you can see, it is not always good to diversify your investments. In fact, it could even backfire. Simply following the "market" or the KLCI is not the intelligent way to invest. What the above examples also show is that, timing the market will most likely lose out to stock-picking through genuine, thorough research. If one could have identified companies such as DIGI or PARKSON in 2003, one's returns would have been extraordinary.

Of course it is very easy to say all this with hindsight. Perhaps, in the future issues, we could examine deeper into some of the indicators that could have led us to purchase these shares in January 2003.

Disclaimer: All company analyses, including the paper portfolio that appear in this newsletter are derived from facts gathered from various sources and the contributors' personal opinions and for education purposes. It is NOT an invitation to deal in securities, and especially not a recommendation for buying or selling any stock. The contributor(s) do not guarantee the accuracy of the facts being presented. The accuracy of such facts are only as reliable as the sources that they are obtained from. Please consult your investment advisers before acting on any information provided by the analyses here.

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