The Power of Diversification

Not everyone believes in Walt Disney's first rule of business that "the customer is always right." At least one point in everyone's life, there will be a situation where they aren't happy with their customer service, and the company just wont care. The reason often boils down to that you're one customer and they have millions.

The reverse happens at work, where your boss is really your customer paying for your services. Often people feel that their boss-customer has too much power and exploits their labor. The reason for this is that you only have one boss and your boss can find thousands of other people providing the same service.

These situations are described as the little guy being pushed around. What makes a little guy little, and how can you become a big guy? The answer is manipulating diversification. As I wrote about in An Argument against Diversification: Pareto Principle, people worry too much about diversifying their portfolio when they need to focus on diversifying their income.

People should try to smash the Pareto Principle as much as possible in their life. Instead of having 80% of your income (typically more) come from one employer, attempt to have no source of income be more than 20% of the total. Now, I'm not saying you have to take five 40hour/week jobs, but you will have to do more work.

The flip side to this is when you purchase services from a company, pick smaller companies. If you can provide 20% of their income, you're in a very powerful position. Of course I suggest that you use this power to build a relationship. Sure, not shopping at Walmart may cost you more, but you're also paying for better treatment.

The Difference in Millionaires

When you picture millionaires at work, visions of private board room meetings spring to mind. However, when you look at the average salary of a football player, these visions should also include dodging human semi-trucks on a grass turf in front of thousands of spectators. Picturing Bill Gates on a football field certainly brings a smile to my face.

Society is seems to focus on making wealth, rather than the various of ways to make wealth. I believe that people should discuss how one should make their wealth. While there is little difference in the end result, illuminating the choices assists in selecting the best path. Just as winning the lottery is sure to make a millionaire, most of us (I hope) do not depend it. The next couple entries will focus on what I've learned.

One Dollar Miracles

My father introduced me to finances and while he wasn't a expert, he had a unique view. One of the things my father taught me was the One Dollar Miracle. To him, it was a literal miracle to get someone to reach into their pocket, pull out a wallet, and give someone else a dollar. This type of transaction isn't as common as we assume. Think of all the people you meet each day, and then count how many you actually give money too. I'll assume that you're not giving money to just everyone.

While my father wasn't successful at making these miracles happen, I'm reminded of it with each dollar I touch. It brings an almost spiritual touch to capitalism, may it help us all in our transactions.

Vacation Post.

I went to Cleveland, Ohio for the weekend and I need to catchup on life. So no updates until Thursday.

An Argument against Diversification: Research Costs

Warren Buffet is someone whom I study because he says what I know to be true, but with clarity that I lack.

"Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing." Warren Buffet [1]

My investment style is heavy on research. I start with a large list of companies whose products I've used or heard about. I hang out with people who are interested in stocks and I hear their stock choices. I then expand the list to include their competition. Then I go through and start research each one until I find the reason not to invest in them. In the end I find a few companies that are quality companies. In any given year, I find only 2 or 3 companies that I would bet my life on, and perhaps I should narrow even that down.

Even if I worked full time on stocks, I don't believe I could find 10 quality companies at fair or discount prices. Anyone who buys a handful of companies in year either has too much time or has done too little research.

Next week, I'll switch to a different series.

[1] Quotes by Warren Buffet, Wikiquote

An Argument against Diversification: Pareto Principle

Pareto principle applied to finances: 80% of your income comes from 20% of the sources. Let's say your income comes from a job, stock portfolio, house, savings account, and blog ads. The Pareto principle would assume that 80% of your income comes from your job. So why is it that most people focus on diversifying their stock portfolio, which counts for perhaps 15% of your income?

While the stock crash at the turn of the century emphasized the impact of losing one's portfolio. This occurred at the same time as many people were losing their jobs. While the stock market crash did sell more newspapers, people would do better to become less dependent on their jobs.

If your portfolio does provide the majority of your income, then I can see the argument for diversification. However, I still have one more argument to make on Thursday.

An Argument against Diversification: Commissions

For each trade you must pay the piper, or the broker in this case. If you're a billionaire making trades that are worth 500,000 dollars or more, then commissions aren't going to affect you. This is due to economies of scale. If you're reading this blog then you're probably trying to squirrel away a few nuts each paycheck. In this case commissions are going to impact you.

Lets say you have 100 dollars to invest and commissions are 10 dollars per trade. If you invest it all into one stock, then it counts as one trade. In this scenario the commission costs you 9% of the total 110 dollars. Remember that it costs another 10 dollars to sell. This means is that your stock has to grow 17% in value before you make a single penny in profit. If you think this sounds bad, lets look at diversifying.

You still have 100 dollars to invest and commissions are still 10 dollars per trade. However, you invest evenly into five companies. This is now five separate trades costing you 50 dollars. Since selling will cost you another 50 dollars your stock has to double before you see a single penny. Simply, the larger your trades the lesser commissions affect your profit.

Diversification protects you from risk, right? It may look like that, but if you calculate commissions as a loss, then the non-diverse portfolio can lose 33% of its value and still be even to the initial investment of a diversified portfolio. The commission on a diversified portfolio would be the same thing as if you payed face value for your shares, and watched them dive 50%. Doesn't feel too comfortable, does it?

Does this mean that you throw diversity out the window? I'd like to say yes, but if you're still want to be divested then buy index funds. Index funds are the easiest and most thorough way to be diverse, and since it's considered one trade, also the cheapest.