How Not To Diversify
Eggs, Moats and Market Madness
Investing Principle: Diversification
“If you invest and don’t diversify, you’re literally throwing out money.”
- Jeff Yass
For new investors, diversification is a must. This is the process of spreading your investments across different stocks or assets in order to reduce the risk of losing some (or all) of your capital. I'll share a quick illustration of my own experience early on in my investing journey, where I did exactly the opposite.
In 2011, I bought my first batch of shares. I was a university student, working part-time and I had just received a back-dated university grant, so I had a decent amount of disposable income. So I decided to invest it all into a few oil and gas exploration companies working in the Falkland Islands. These were the companies:
Rockhopper Exploration (RKH.L)
Borders & Southern Petroleum (BOR.L)
Argos Resources (ARG.L)
Desire Petroleum
I was extremely optimistic (and naive), as I believed that stocks only ever went up. I did very little research on these companies I had invested in. I couldn’t tell you how they made money, who the leaders were or whether they had a history of meeting or beating their own expectations. What I did know was that they were oil and gas exploration companies and so naturally, I thought they would find a lot of oil and gas and make me rich - quick! A significant chunk of my money went into Borders & Southern Petroleum, simply because I found it to be ‘cheap’.
In July 2012, I logged in to my investment account to check how much closer I was to hitting the jackpot. This was with high hopes that these companies would have discovered oil or gas, driving up their share prices in the process. I was actually shocked to discover I hardly had anything left in my account. Here’s what had happened to Borders and Southern Petroleum:
Chart: Yahoo Finance
The sharp dip pretty much tells you all you need to know. Unfortunately for me, the company had discovered gas off the coast of the Falkland Islands, but could not drill deep enough to actually do anything about it. The share price fell 70% in one day as investors sold off in response. It has not recovered since.
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
- Warren Buffett
The problem wasn’t just that I had lost most of my investments in one company, but rather the headline had affected all 4 companies operating in that region. I was so dumbfounded I called my broker to confirm what I saw in my account was real. I did not pay any attention to risk or consider ways of protecting my portfolio at the time through diversification. The phrase ‘investments can go up as well as down’ did not register with me until my investments actually went down. To note Buffett's quote, I did not know what I was doing, so diversification would have been an ideal hedge against my own ignorance. It was an expensive lesson to learn.
The aim here is to maximize returns while reducing risk. Although it is impossible to have a zero-risk portfolio, it can still be managed by owning investments that do not all respond to outside forces in the same way. A portfolio should not just be a mere list of your best ideas, but rather that the ideas work well together. Here are some examples of diversification:
Buying into Mutual or Index Funds
Mixture of Stocks and Bonds
Stocks in different sectors
Adding commodities (e.g. gold)
Risk management is important, however, too much diversification can limit returns. As you grow and become more comfortable investing, concentrating your portfolio to a specific asset, sector or region can be beneficial and could generate larger returns in the long run.
Investing Jargon: Business Moat
A ‘moat’ refers to a company’s durable competitive advantage. It is the distinct advantage they have that keeps them ahead of their competitors, allowing them to protect or grow their market share.
Amazon’s $1 Trillion Network
Amazon’s ability to build and sustain a network bringing together buyers and sellers created a Network Effect moat. This is simply when a product or service increases in value as more people use it.
In Amazon’s case, the more suppliers and customers added to their network, the stronger the network (and brand) became. Customers purchasing products at low prices in turn attracted more customers. More customers drew more suppliers to sell via Amazon and the cycle continues to this day. What started as an online bookstore in the ‘90’s eventually grew into the world’s leading online retailer. They have expanded their business in a variety of ways, but the success of Amazon Prime has been a huge driver of their market dominance, with over 100 million prime users in the US alone.
Below, we can see how their market cap has grown over time as they continued to strengthen their moat, adding a variety of products and services along the way:
Chart: MacroTrends
After reaching the $100bn mark, their market cap exploded to $1.7 trillion in 2020. That is some dominance! You can view a breakdown of their revenue model here.
Other examples of companies which have Network Effect moats are:
Facebook
Uber
Apple’s IOS ecosystem
Long-term investing in businesses requires you to study their moat, as it is one of the most important aspects of stock research. A strong and growing moat increases the chances of large returns for investors. A weak moat suggests a company will likely see any market share they have decrease as competitors develop better products or services.
Market Madness
With Bitcoin continuing its surge from 2020 and reaching all-time highs this year, this poor fellow has two password attempts left to access 7002 Bitcoins worth over $200m (at the time of writing).
Meanwhile, the U.S. government are planning another stimulus package and bond interest rates are as low as they can be for now. It'll be interesting to see whether stocks continue their increase through 2021 as a result.
This tweet by Elon Musk had investors pouring into Signal Advance stock (SIGL) so much so that it jumped from $0.65 per share to nearly $40 in a matter of days, roughly 6,000%(!). Good news for investors already holding the stock prior to the tweet, but there was a slight problem for new investors.
The stock was completely unrelated to Musk’s tweet. Musk was referring to Signal, the encrypted messaging service as an alternative to WhatsApp. Signal Advance is a small healthcare tech company, minding their own business and operating in relative obscurity - until now. Basic rule of investing: do your own research and don't follow the crowd.
I hope prior holders of Signal Advance stock cashed out and enjoyed their profits.
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