A Dangerous Way to Invest

This is the story of Andy Zaky. Zaky was a law graduate from UCLA who started making a name for himself in 2008 by forecasting Apple’s 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, the financial hub of America.

But, the fairy tale turned into a horror story when Zaky lost it all after Apple’s share price started its descent from US$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 contains a telling lesson for investors. He had made two very avoidable mistakes in investing: 1) a failure to diversify, and 2) abuse of leverage.

Failure to diversify

Zaky’s entire portfolio consisted of Apple, Apple, and you guessed it: Apple. Simply said, having a portfolio with a complete lack of diversification is one of the worst ways to invest.

There are many things that can go wrong when we invest in a company’s shares, and there are some risks that we just 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 say 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 the 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 to spread some risks.

In Singapore, we have the SPDR Straits Times Index ETF (SGX: ES3) and Nikko AM Singapore STI ETF (SGX: G3B) that tracks the movement of Singapore’s stock market barometer, 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.

Abuse of leverage

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

To borrow from John Maynard Keynes, “The markets can stay irrational long than we can say solvent if we’re leveraged.”

While it is important to avoid leveraged investment strategies on a personal basis, finding investments that aren’t heavily levered also cannot be neglected.

Take for example, the experience of the three local banks – DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank (SGX: U11) – during the Great Financial Crisis that occurred from 2007 to 2009.

The three banks had side-stepped the crisis admirably even as western banks like Citigroup were buried neck-deep in losses. The reason? DBS, OCBC and UOB were all utilising much lower leverage compared to the likes of Citi.

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. If we do, we are no longer investing, but gambling. And according to a Chinese saying, “9 out of 10 gambles are lost.”

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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 of Apple.