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A Dangerous Way to Invest

This is the story of Andy Zaky. Andy Zaky was a law graduate from UCLA who started making a name for himself in 2008 by forecasting Apple’s (NASDAQ: AAPL) earnings, and subsequently its product sales and share price movements with eerie accuracy. He eventually developed such a large following that he offered a paid newsletter service for stock-market tips and amassed US$10.6m from investors to run an Apple-only hedge fund. In short, it could have been a romantic story of how a non-finance trained person managed to outsmart the wizards on Wall Street, America’s financial hub.

But the fairy-tale soon turned into a horror story when Zaky lost it all after Apple’s share price started its descent from $700 on Sep 2012. His hedge-fund went practically belly-up while his newsletter subscribers also made losses following his strategies. In the aftermath, Zaky’s experience is a telling lesson for investors. He had made two very avoidable mistakes in investing; 1) failure to diversify and 2) use of leverage.

Failure to Diversify

Zaky’s entire portfolio consisted of Apple, Apple, and you guessed it.. Apple. That is one of the worst ways to invest – a complete lack of diversification. There are many things that can go wrong when we invest in a company’s shares, and there are some risks that are just we can’t forecast in advance. That is why we diversify when we invest to lower our risks.

Spreading our bets also helps bring peace of mind when we invest so that we can sleep soundly at night. If a company’s shares make up 5% of your portfolio, instead of 50%, any sudden fall in its share price will be less painful. Best of all, having peace of mind would also mean smaller chances of making rash, emotionally-driven decisions which tend to be harmful for investing.  It is likely that Zaky fell victim to his emotions, judging from the “emotional and bombastic’ comments on his own message boards.

Even though we at Motley Fool Singapore would much prefer to invest in individual companies, there are folks who would prefer to save the trouble and just invest in the overall stock market to diversify risks. In Singapore, we have the SPDR Straits Times Index ETF (SGX: ES3) and Nikko AM Straits Times Index ETF (SGX: G3B) that tracks the movement of Singapore’s flagship stock-market index, the Straits Times Index (SGX: ^STI). Investing in the ETFs would be akin to investing in Singapore’s stock market itself and while you can’t beat the market because you are investing in the market, long-term investors can still perform relatively well.

Use of Leverage

Leverage, in financial matters, is the proverbial double-edged sword. It can help or it can harm. Assume an investor has $1m in capital and he borrows $29m to purchase investments that total $30m. A 5% advance in his investments would mean a gain of $1.5m or a 150% return on his capital – that’s fantastic! But… a 5% decline in his investments would mean a loss of $1.5m and the investor would be completely wiped out, even if the investment eventually rebounds.

That’s the power of leverage and those are the powers Zaky was trifling with when he betted on Apple’s stock price movement through options, getting burned badly in the process. Even though Zaky did not technically borrow money, options are in effect, leveraged financial instruments.

While it is easier to avoid leveraged investment strategies on a personal basis, sometimes leveraged investments might slip through our net. For example, here in Singapore, S-REITs are heavily sought-after by investors chasing yields, but these trusts are inherently highly-leveraged entities that might run into trouble when credit freezes up.

In the Global Financial Crisis of 2007/2009, Ascendas REIT (SGX: A17U) was downgraded by credit-rating agency Moody because of the possibility of the REIT having trouble making interest payments on its debt. Credit downgrades are important for highly leveraged entities because it makes it even more expensive for them to borrow money, landing them in a vicious cycle of interest-payment difficulties and pricey debt. Ascendas eventually managed to avert trouble by adroit management of its capital and retention of high occupancy rates in its properties.

The Foolish Bottom Line

It is easy to forget how risky leverage can be because of the promise of massive gains on our invested capital should things go well, but we should never forget to think of the negatives that can happen. Diversification is also important and we should know never to risk all our eggs in one basket, no matter how attractive that basket is, because if we do, we are no longer investing, but gambling. And according to a Chinese saying, “9 out of 10 gambles are lost”.

To follow our thoughts and opinions here at The Motley Fool Singapore, click here now for your FREE subscription to Take Stock Singapore. Written by David Kuo, Take Stock Singapore is our free investing newsletter that tells you exactly what’s happening in today’s markets, and shows you how you can GROW your wealth in the years ahead.

The Motley Fool’s purpose is to help the world invest, better.   The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Contributor Chong Ser Jing owns shares in Apple.