What You Don’t Know about Diversification Can Hurt You
Regular everyday well-meaning investors are trained by many money managers and financial advisors to diversify, so ‘when the market varies you won’t have all your eggs in one basket’. “Spread the risks,” they say – among dozens of stocks. In other words, if you buy stocks or other investments, adapt a passive attitude and learn to take your lumps and do nothing. You should seriously question this attitude.
There is a very popular investor who has ignored this advice for years and is one of the richest people in the world, Warren Buffett. There are some good books on how he does it and well-worth the read, but I am going to share, in my own words of course, what I believe to be the essence of this genius investor. What I admire most about Warren Buffett is that what he does is little more than common sense and quite logical, and yet it goes against virtually every money manager that urges people to diversify widely to avoid risks.
I’ll explain it right now in simple language and you make up your own mind: If you owned a stable of 100 thoroughbred race horses, and 10% of them won 95% of the races, why would you enter all 100 or even 80 of them in the races? You wouldn’t! And that, my friend, is how easy it is to show you the essence of good investing. There is a current day movement among modern managers that is ditching the long-held -and perhaps overly simplistic view- of safety in diversification – and it’s about time.
This doesn’t negate nor deny investing in various kinds of assets for safety, but if you are going to put money in stocks, you might want ten good ones instead of buying 100 with a shotgun approach. And when you do get those windfall profits, you might consider protecting profits instead of just passively letting it ride – as a strategy. If, in your investing, you have assumed that MORE information is always better than LESS, then you have no discrimination; you need to get a bridle on things. Reel it in and become a specialist in making profits, not a player in the futile game of ‘trying to know everything.’ You will be like a bird that dies from exhaustion because he cannot decide where to land.
Beware of money managers who tell you ‘take your lumps’ and to expect a few major setbacks. Learning to use options for protection is nothing more than choosing the right tool for the right job. It makes perfect sense to learn to make better choices about protecting what you have made. You took risks to make that money and it paid off; now doing nothing to protect it may be taking risk unnecessarily. Savvy investors know that doing nothing is a choice with consequences. If you made 50% profits in your account in five years, would you spend 1% of your profits to protect it? You probably answered ‘yes’; options can be an inexpensive way to protect what you’ve already accomplished – and in the long run, keeping what you make will have you making even more. Anyone who learns to make money but fails to learn how to keep it, doesn’t really understand investing; they only have half of the equation.
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