The Portfolio Diversification Lesson: What You Can Learn From my Friend’s Mistakes
During the technology euphoria in late 1999 and early 2000, I recall that a friend of mine had taken out a massive loan against the value of his home and bet on several high-risk micro-cap stocks. I remember his position surging from $100,000 to nearly two million dollars in less than two months. He asked me my investment advice on what to do. I said take profits. He did not listen and sat on the two stocks all the way back to well below his initial investment!
This is a true but sad story that I have used as an example on the need of portfolio diversification. The reality is that it doesn’t matter if you are investing in real estate, the stock market, art, or antique cars. The best way to protect your wealth is not to put all your eggs into one basket. This is obvious, but I’m surprised how few investors actually follow this guideline.
One of the keys to successful investing is longevity. The longer you are in the business of investing in the stock market, the more experience you gain and the more opportunities cross your path.
When you are buying a stock, you are investing in a business. The people that run that business are entrepreneurs, looking to generate a return on the capital their company invests. The people who provide this capital are investors—people like you. You invest your capital because you are looking to generate a decent return on your investment.
Naturally, if you are going to invest your money in a business, you want to have some say in how it is run, in order to protect your investment. In the stock market, however, you don’t have that luxury.
You can vote for company management or some specific initiatives, but you can’t actually participate in the company’s daily decision-making. So, this means that you do not have control over a company’s ability to allocate your capital. Therefore, the only option available to you as an individual investor in the stock market is to spread your investment capital around. You need to divide your own investment risk among a number of companies, because you can’t control the actions of any one of these entrepreneurs.
The phrase used to describe this spreading of investment risk is portfolio management.
Portfolio management is a process that encompasses the creation, monitoring, and adjustment of your investments. The process never stops, because you are continually buying and selling new stocks. Taking a “portfolio approach” to your stock market investments helps you stay in the game longer and improve your returns.
Taking a portfolio approach to your stock market holdings means diversifying the industries in which you invest. Not only do you need to spread your investment capital around a number of different stocks, but you also need to diversify your holdings across different industries. Owning a basket of stocks in one market sector increases your investment risk substantially, so you have to spread your money around different sectors if you want to protect your wealth over the long term.
Trust me. My friend was greedy, not diversified, and suffered major losses. I don’t want you to be like him.