Riddle of risk and reward

Q: I only started to see phenomenal gains in the sharemarket when I began to pick stocks.

I used to have a "basket" of shares but inevitably the gains of one stock were nullified by the losses of another.

Obviously, it's riskier to invest in one or two stocks, but is it much riskier to invest most of one's share-allocated money in a bank's shares rather than its term deposits or savings accounts?

Moreover, there are some good relatively low-risk utility stocks on the market at the moment - Auckland Airport and Contact Energy - that have shown virtually unabated growth in capital gains and dividend yield from the time they were first floated. Indeed, that growth is highly likely to continue, notwithstanding external factors affecting the entire market.

Obviously, one has to be careful when investing in a smaller number of shares, but I'm not advocating high-risk internet or biotech shares.

I'm also not for trading too much; far better to hold and reinvest dividends over the long term.

It's good to diversify over asset classes but to over-diversify in shares is to diversify away future profits.

A: And losses.

You're absolutely right that if you hold lots of shares you won't get the extraordinary gains that are possible with just a few shares. And it sounds as if you've been one of the lucky ones who has made those gains.

But your second sentence could just as well read, "the losses of one stock were nullified by the gains of another". Gamblers don't diversify. But most people are willing to sacrifice the possibility of huge gains for a reduction in huge losses.

And that doesn't mean you can't still do very well, thank you - or badly for that matter - with a basket of shares.

In the late 1990s, a broad-based investment in international shares or a share fund rose more than 30 per cent some years; early this decade it fell about 30 per cent a year for a couple of years.

On your question about a bank share, yes it is much riskier than term deposits or savings accounts.

Neither idea is good for "share-allocated money". Deposits and savings accounts will give a much lower average return, over the long term, than a well-diversified share investment.

But putting most of the money in a single share is taking unnecessary risk. Okay, a bank probably won't go broke, leaving you with nothing. But that doesn't mean shareholders can't suffer losses.

The price of every share, including shares in the most rock-solid company on Earth, goes down sometimes - perhaps because of new competition in the market.

Utilities are certainly not as volatile - or as likely to go under - as internet or biotech shares. And Auckland Airport and Contact Energy shares have, indeed, performed well. But there's no way of knowing whether that will continue.

Even if the companies' prospects are excellent, as long as that is widely known, many people and institutions will have already bought the shares. The demand will have pushed the prices up to a point at which new buyers can't benefit from those prospects.

The share prices will continue to grow fast only if new positive information comes out.

If, instead, the companies simply continue as expected, their share prices probably won't rise much at all, even though business might be booming.

The crux of the matter is this: it's not how well a company is doing but whether it is doing better or worse than expected that moves its share price.

No share is a sure bet. That's why shares tend to pay higher average returns, over the long run, than other investments - to reward investors for taking risk.

I suppose you can over-diversify in shares - if you're investing directly as opposed to via a share fund - in the sense that you've got more paperwork to deal with. And it's true that the risk reduction from diversification is slight after you've got more than 20 shares with roughly even holdings.

With fewer than 20 shares, though, I can't agree with you - unless you like gambling.

However, I do agree heartily that buying and holding is better than trading, and that dividend reinvestment is a great idea.

Q: Greg Norman may well have said that the harder he worked, the luckier he got, but the statement originated with South African golfer Gary Player.

A: Sorry. You're right. The correspondent on November 20 said it was Norman and it didn't occur to me to check up on it.

You wouldn't by any chance be South African, would you? It's discouraging when a countryman's achievements - and a good quote is certainly an achievement - are attributed to somebody from elsewhere.

We Kiwis are familiar with that when the conversation turns to pavlovas.

Q: Please could you give me some information on books that I could read to learn about investing? I am 20 and want to start learning about all the different options, so that I can make the right choices.

A: Good on you for starting so young.

As it happens, the Reserve Bank has just published a free 48-page booklet that I've written explaining the basics of investing. It's called Snakes And Ladders: A Guide To Risk For Savers And Investors.

To get a copy mailed to you, email your name and address to the Reserve Bank (see below), phone them on 04-471 3770 or mail to The Knowledge Centre, Reserve Bank, PO Box 2498, Wellington.

Alternatively, you can read Snakes and Ladders on the RBNZ website (see link below) and print it out from there.

For the record, I was paid a commission to write the book, and I don't receive royalties, so I'm not trying to peddle it.

Other books? I could mention my Investing Made Simple, published by Penguin and available at bookstores, but I do get royalties on that so perhaps I'd better not! Beyond that, I'm not a fan of Robert Kiyosaki, who wrote Rich Dad, Poor Dad and many follow-ups. He advocates taking more risk than most people would be comfortable with.

Browse libraries and bookstores. Be wary of "get rich quick" claims and check out the credentials of the authors.