In 1965 a 47 year old lawyer named André-François Raffray approached a 90 year old woman about purchasing her apartment. They signed a deal in which Raffray agreed to pay the woman 2500 francs per month until her death, at which point the apartment would be his.
Unfortunately for Raffray, the woman was Jeanne Louise Calment – who lived to be 122 (the longest confirmed life span on record).
Raffray ended up playing the equivalent of $180,000, more than twice the value of the apartment. He died two years before Calment.
The lesson from this story is that sometimes things just don’t work out the way they should. No matter how finely tuned your investment thesis is, there’s always a risk you could be totally wrong. In other words, there’s no such thing, as a sure thing.
Good investors understand this and take the necessary precautions to manage risk.
Stocks by their very nature are risky. If you have zero-tolerance to risk, stocks are just not for you. Even the most established companies with a long track record of positive returns and dividends have risk. The larger and more established the company, the lower the risk. The smaller and younger a company, the higher the risk.
Is Google (now Alphabet) going to be a bigger company in 10 years or will it be bankrupt? It’s probably 99.9% the former, but there’s no such thing as a sure thing.
If you think it’s totally impossible that Google would go bankrupt think again. Lehman Brothers, Enron, Worldcom, CIT Group, Pacific Gas and Electric, Delta Airlines, Washington Mutual, Blockbusters, Kodak, General Motors, Chrysler…the list goes on and on.
There’s risk in every investment but that isn’t necessarily a bad thing. A good investor understands that risk is simply the price you pay for higher potential returns. How you manage that risk is a personal decision, but every great investor understands that you can’t do this without diversifying.
Diversification is the silver bullet of risk management. There’s no other way to properly protect yourself against the unforeseeable 122 year old woman.
You should build a diversified portfolio over time – aiming to own between 10-30 stocks. The more stocks you own, the more diversified you are, but owning too much will dilute those higher returns until you’re left with something similar an index fund.
There’s three basic ways you can diversify between stock.
You can buy a basket of companies of different sizes. As we know, the bigger and more established the company the lower the risk. So you should own a few safe companies. I like to refer to these as bedrocks – companies that are so well known and established that even if they make huge missteps, the market will forgive them over time. But those companies aren’t going to net you those great returns. That requires investing in smaller less established companies with the potential for high growth. You may think investing in a small tech startup that’s not profitable yet is risky; but if it’s the riskiest stock in a portfolio of nine other large cap companies, then you haven’t got a risky portfolio.
Diversifying between different industries is vital. Owning 30 different internet stocks does not mean you’re protected. The Wall Street Journal’s Jason Zweig said it best; “That’s like thinking an all-soprano chorus can handle singing ‘Old Man River’ better than a soprano soloist can. No matter how many sopranos you add, that chorus will never be able to handle the low notes until some baritones join the group.” So aim to spread your investments over at least three industries.
Finally look to include in your portfolio some companies that are not totally reliant on the US economy. A company like Coca-Cola makes money in practically every country in the world. A downturn in the economy will hurt, but not to the extent that it will hurt a company like Chipotle, who only operate in the United States.
There’s no great secret to building a diversified portfolio; keep it varied and balance your risk. Any major shocks won’t hurt too much and you’ll increase your chances of finding that one incredible stock.