You’ve worked hard, kept your cost of living low, saved a good percentage of your salary, and now you want to make your money work for you. If you’re a regular reader of The Motley Fool, you’ll know the benefits of investing in stocks over holding cash: much higher average rates of return and protection against inflation.
However, there’s a caveat. Higher rates of return tend to come with higher volatility. That means the tendency for prices to fluctuate, and one thing that’s undeniably true of stocks compared to bonds or cash is that their prices tend to fluctuate a lot more. Of course, this is what makes stock investing so potentially lucrative: the possibility of buying something for less than it’s worth.
Be careful even if you are sure you are right
Due diligence and research are obviously crucial to the process of selecting a good stock for your portfolio. You should never buy a stock without careful examination of all its financial records, and a sober assessment of all the possible things that could happen in its sector and market. But say that you’ve done all of that, and you’ve fallen completely in love with a company. Should you go all in on it?
Putting all of your eggs into one basket might not be the best idea if you’re someone who gets nervous at the idea of your retirement savings fluctuating. But even if you have nerves of steel, you should think twice about deploying all of your capital in one go. To slightly paraphrase Seth Klarman, a well-known value investor: “Investing requires both arrogance and humility.” You have to be sure enough that you — the buyer — are right and that the seller is wrong, but at the same time, you need to have the humility to recognise that there are limits to even the most thorough research.
To paraphrase another scholar of the human condition, former US Secretary of Defence Donald Rumsfeld: “There are known knowns, there are known unknowns, and there are unknown unknowns.” Although Rumsfeld was ridiculed for the awkward language of this actually-much-longer speech, I think that investors can learn a lot by adopting this view of the world.
The biggest risks you face as an investor are not the ‘known unknowns’ that you can anticipate, it’s the ‘unknown unknowns’ that you can’t. In late 2015, who could have foreseen either Brexit or a Donald Trump presidency?
Diversification is key
This is the real reason why good investors diversify their portfolios — not because they don’t have confidence in their analysis, but because they understand the practical limits of human knowledge. By buying stocks in a wide range of sectors and geographies, and potentially even adding other asset classes, you can insulate yourself from the volatility that will inevitably come from living in a complex world. If one stock tanks, you don’t lose your entire investment. And besides, there are a lot of high-quality stocks out there, so why limit yourself to just one?