Safety comes from spreading it wide

Q: There is an issue that your readers might consider when they try to diversify their portfolio.

Diversification is not related to the number of different shares that you have in your portfolio.

Having a portfolio of many real estate developers is not diversification, even if you have 20 different firms in your portfolio. Diversification depends on the relationship between those shares (their correlation).

You can have a diversified portfolio by holding a biotech share, a computer software share and shares in a hedge fund. You have a risky portfolio but well diversified nonetheless.

A: You make a really good point that I should have made more clearly in recent columns. I think, though, that you overstate your case.

The more shares you hold, the more diversified you are - even if they are all in the same industry.

While economic, legislative and other factors affect all the companies in an industry, there are also many company-specific factors that affect a share price.

The most obvious is quality of management.

So it's quite possible for one property developer share to go down while another goes up.

Nevertheless, you certainly do get much better diversification if you spread your money across as many different industries as possible.

It's also good to vary the size of the companies and, particularly, the countries in which they are based.

Adding international shares makes a huge contribution to risk reduction.

Your example - of biotech, software and hedge fund shares - gives industry variety. But with only three shares, you are still missing much of the benefit of diversification, even though the hedge fund investment would involve several companies.

It's best to hold at least 10 widely varied shares, with no holdings so large that they dominate the portfolio. And 20 or 30 is better.

Q: In quoting how much bad timing can reduce returns, you repeat a fallacy that brokers have been spreading since the United States bull market collapsed.

If we use local figures, the total return (NZX gross index) from investing in the New Zealand market for the 10 years to November 2004 would have been 10.8 per cent annually.

An investor who traded in and out of the market and happened to miss the best five days in those 10 years would have had returns of only 8.3%; missing the best 30 days would reduce the return to 2.1%.

These are much like the US figures that you quoted, although we escaped the absurd run-up of the US bull market so our returns are not quite as dependent on a few outstanding days.

The fallacy is that a frequent trader is just as likely to miss the worst days as the best.

Missing the five worst days would have boosted returns to 14.8 per cent, and missing the 30 worst would have produced a spectacular 22 per cent annual return.

In fact, investors are far more likely to win Lotto than to miss out on exactly the five best (or worst) days in a decade.

What they would really miss are five ordinary days, so their return would still be very close to 10.8%.

The arguments for staying in the market with a buy-and-hold strategy have nothing to do with silly ideas about the risk of missing a few brilliant days.

They are:

* Every time an investor or fund manager buys or sells, the investor pays a brokerage commission.

It doesn't take many trades a year to reduce returns a lot.

* People don't pick neutral or random times to get in or out.

Psychologically, most of us feel ready to invest when the market has been going up for a while, and sell out when it has been going down for a while.

This applies as much to investors in funds as to those who buy shares directly. So investors tend on average to buy high and sell low. (Me too.)

Unless one has the discipline to avoid this mistake, it is much better to stay permanently in or permanently out of the market. (One exception: investors who strictly follow technical analysis theories are likely to buy and sell at random times, so will get about the normal returns, less commissions.)

But if they cheat, they will reduce their returns on average, just like the rest of us.

But good on you for stressing that timing is a mug's game.

Anyone who claims to be able to consistently time their trades right either has inside information or is deceiving themselves - most likely the latter.

Your readers should not be deceived with them.

A: Fair enough - well, almost.

I don't entirely buy your criticism of the missing days analysis.

Given that sharemarkets rise over the long term, there must be many more good days than bad.

So an investor who is frequently in and out of markets should expect to miss more boom days than bust days.

Also - and this is only a quibble - I seriously doubt that it's brokers who have been spreading the "fallacy".

They get much more brokerage from investors who get in and out of shares than from those who buy and hold.

Beyond that, though, I bow to the superior thinking of a professor of accountancy!

Q: I always thought it was the great Arnold Palmer who first said: "The more I practice, the luckier I get".

A: It seems he did. And Gary Player said, "The harder I practise, the luckier I get," as well as "The harder I work, the luckier I get".

Samuel Goldwyn also said that last one, as did Sam Shoen. And Ray Kroc said: "The more you sweat, the luckier you get."

And Thomas Jefferson said: "I'm a great believer in luck, and I find the harder I work, the more I have of it."

And, and, and ... the more I searched on Google, the more confused it made me.

Perhaps we'll just have to settle for the fact that it's a great quote, whoever said it.