Tuesday, January 20, 2009

Don't put all your eggs in one basket!

It's the simplest concept in risk management and one that comes from the Grandmother Book of Wisdom but is one that tends to be ignored time and time again. At it's core is the principle that in order to reduce risk you should make more rather than fewer risky decisions - don't put all your eggs in one basket.

Recently the media has been full of the "basket bank" that is Anglo Irish Bank. The shareholders attended an EGM last Friday and their stories have featured over the last few days. From The Irish Examiner:

HALF a century after he left the garda√≠, John O’Leary still regrets taking the £89 he was offered in lieu of leaving his pension contributions with the force. But it was 1954 and he needed the money to pay his passage to England where he had hopes for a prosperous future. He did all right, getting a modest job with Beechams, but his only pension now comes from Britain and it’s a pittance, especially with the decline in sterling.

That’s why, five years ago, he began taking whatever small savings he could muster and putting them into Anglo Irish Bank shares. Yesterday the 85-year-old from Cobh, Co Cork, all but accepted those shares were worthless.

“Everything I read about them, everything I heard about them made them out to be a sound investment.

I wasn’t greedy. I didn’t expect to make a fortune. I just needed to make an extra bit of money to provide for myself. You have to take responsibility for yourself and that’s all I was trying to do.”

Retired couple, Anne Louise and Charlie Moore, both aged 69 and living in Tullow, Co Carlow, said priority should be given to old age pensioners’ dividends in deciding how to continue the bank’s business.

Anne Louise has multiple sclerosis and said she couldn’t live on the state pension alone so the dividends from her investments were crucial. “We do have other shares but unfortunately they are in other banks and they are not doing well either.”

The first investor here had no diversification and is left with little or nothing. The second couple did have a number of different shares. Unfortunately, there were all companies in the same sector and as such were highly correlated. Owning these shares did nothing to reduce their risk.

This isn't the first time the country has failed to grasp the concept of diversification. Due to EU laws requiring the opening up of the Irish telecommunications market, Telecom √Čireann was privatised. The process began in 1995, and by July 1999 the government had disposed of virtually all of its shareholding. eircom plc was then floated on the Irish Stock Exchange, London Stock Exchange, and New York Stock Exchange on July 8, 1999 and small/first-time investors were encouraged by the government to buy shares. The government undertook a huge advertising campaign encouraging people to buy shares. This was to try and increase stock market participation among the general population. More the 500,000 participated in the initial public offering.

The share price was set at €3.90. It later reached a high of €4.80, a 23% increase. Those initial investors that held onto their shares until July 2000 received a 4% bonus share allocation.

However after the initial hype of the flotation died down, the stock price fell rapidly. Eventually in November 2001 the company agreed a recommended offer of €1.335 per share from the Valentia Consortium headed by Tony O'Reilly. Many of the 500,000 small investors were angered by the significant financial loss they incurred, blaming the government for not sufficiently warning them of the risks inherent in stock market investment. They had all their eggs in one basket!

The next occasion when Irish government policy was linked to general participation in stock markets was with the launch of the Special Savings Investment Accounts in 2001. People who signed up for the scheme had a choice of three types of account. The accounts are listed in increasing order of riskiness.
  • Fixed Rate Cash Account
  • Variable Rate Cash Account
  • Managed Equity Fund Account

After being burned on the eircom privatisation people were less willing to go for the equity accounts. In fact less than 25% of the more than one million accounts opened were equity based. Although the equity accounts performed poorly in the early years of the scheme by the end of the scheme they had outperformed the interest bearing accounts. The following data on the final values of the accounts is taken from this report.

  • Fixed Rate Cash Account: €21,073
  • Variable Rate Cash Account: €20,176
  • Managed Equity Fund Account: €25,922

Bank of Ireland provide a similar analysis here. The managed equity fund was nearly 25% higher than both of the cash based accounts. They didn't put all their eggs in one basket!

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