Why Diversification Matters More Than Picking Winning Stocks
Key Takeaways
- Diversification helps reduce investment risk by spreading your money across many companies instead of relying on a few winners.
- Concentrating your efforts can be beneficial when you have unique skills or expertise, but investing requires a different approach.
- Trying to pick winning stocks or time the market can put your long-term financial goals at risk.
- A disciplined, diversified investment strategy can help you build wealth while avoiding unnecessary risk.
You've probably heard the saying, "Don't put all your eggs in one basket."
The phrase is often traced back to the novel Don Quixote:
"It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket."
The message is simple. It can be risky to keep everything valuable in one place.
In investing, this idea is known as diversification. Rather than trying to pick a handful of winning stocks, we spread our investments across many companies to reduce risk.
But let's be honest.
Putting all our eggs in one basket isn't always a bad thing.
Sometimes, concentrating our efforts is exactly what helps us succeed.
The trick is knowing when concentration makes sense and when diversification is the smarter strategy.
Understanding Diversification
Diversification is one of the most widely accepted principles in investing. It helps reduce the risk that comes from relying too heavily on a single company, industry, or investment.
Interestingly, this principle doesn't always apply to every area of life.
Sometimes, putting all your energy into one thing is exactly the right decision.
My Journey in Finance
In high school, I took an accounting class and loved it.
The numbers had to balance, and we used clean mechanical pencils on finely lined green column paper. Everything about it appealed to me, while very little else in school did.
During my second semester of college, I was required to take a finance class on my path toward an accounting degree.
Everything changed.
I quickly realized the difference between the two disciplines.
Accounting records the past. Finance determines the future.
From that point on, my focus shifted completely to finance.
I earned my undergraduate degree in finance in 1990, completed my master's degree three years later, and have spent my career focused primarily on investments.
Looking back, it's easy to say I put all my eggs in one basket.
Was that wrong?
Not if it works out for you.
And if it doesn't?
The good news is you can always change course.
The "eggs in one basket" rule doesn't always apply. When you have unique talent or passion in a particular area, concentrating your efforts can help you stand out from the crowd.
Investing, however, is a different story.
Investing Is Different
After managing money for more than 25 years, I can honestly say:
No one beats the market consistently over time.
A diversified portfolio has historically been a much more reliable way to fund a retirement that may last 30 years or more.
Like all of us, though, we can be tempted to stray from this simple strategy.
Wall Street often benefits when investors make frequent changes to their portfolios.
Financial media also benefits when investors constantly feel the need to do something.
Together, those influences can push us toward unnecessary changes instead of disciplined, long-term investing.
How Do We Address This?
Whenever you're tempted to abandon your well-diversified portfolio, ask yourself these three questions.
1. If this decision works exactly as I hope, how will my life be different?Could you retire earlier?
Buy a larger home?
Help your children or grandchildren financially?
Picture the outcome clearly.
2. If this goes spectacularly wrong, how will my life be different?
Imagine losing 50%, or even all, of your investment.
Would retirement be delayed?
Would your spouse have to return to work?
Would you have to move?
Make the downside just as real as the upside.
3. Have there ever been things I was absolutely certain about that didn't work out the way I expected?
This is the toughest question.
It forces us to step outside our emotions and honestly evaluate the risks we're taking.
These questions help us weigh the upside against the downside before making decisions that could permanently affect our financial future.
Understanding Loss Aversion
That uneasy feeling you get when imagining the downside has a name.
Loss aversion.
Loss aversion describes our tendency to feel the pain of losses much more strongly than the satisfaction of equivalent gains.
That's important because none of us can predict where markets will go next.
Sometimes we convince ourselves that this time we'll be right.
That confidence can become one of the greatest risks to a successful financial plan.
What Gets in the Way?
Usually...
We do.
Perfectly intelligent people convince themselves that their company stock is about to skyrocket and take on far more risk than they actually need.
Others become convinced the economy is about to collapse, move everything into cash, and wait for the "perfect" buying opportunity.
I view both approaches as equally risky.
If we weren't all so susceptible to these emotional traps, they would seem obviously unwise.
The Good News
The solution is surprisingly simple.
Build a diversified portfolio that owns as much of the public markets as practical.
Keep your investment costs low.
Take only the amount of risk you truly need.
Then...
Do nothing.
Doing nothing sounds easy.
It's also the hardest part of successful investing.
Having trouble keeping your eggs in different baskets?
I'm here to help.
To share your comments, send me a direct email at Joe@BestFinLife.com.
Or, if you're ready to have a conversation about improving your financial life, schedule a complimentary virtual conversation here.
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