Diversification
Rule #1: Investing for Dummies
Why settle for average when you keep reading about people who made life-changing stock picks and made millions?
It’s such a tempting daydream because it wouldn’t have taken Master of the Universe-level genius to beat the market between 2010-2020. During that time, two of the best-performing S&P 500 tech stocks were Netflix and NVIDIA. If you had just owned those stocks then, you would have clobbered the index. By a lot.
Most people intuitively understand the benefits of spreading their bets in the stock market, or what is called “diversification.” If you’re seeking green M&M’s, grabbing a big handful from the bowl is a much better way to be sure you get a green than just picking one M&M at a time blindly. For investors, that means buying an index fund or ETF rather than just a single stock.
But again and again, so many people don’t take this basic precaution and instead try to find those green M&M’s on their own. A study looking at tens of thousands of individuals’ portfolios found that the vast majority were under-diversified. That can be in simple ways, like by just owning shares of too few companies, or in slightly more complicated ways, like by owning too many shares that all move in the same direction under similar market conditions.
Consider this: If instead of Netflix or NVIDIA you had picked Facebook or Google parent Alphabet, you would have under-performed someone who bought the Vanguard Information Technology ETF (ticker symbol VGT).
The fact is, picking stocks that will beat the market is actually really hard. Even if you get it right, it meant you took a lot more risk than you probably wanted to. And if you’re picking just a couple of stocks for your whole portfolio, you’re not investing—you’re trading.
Rule #2: Action By Being Inactive
There are great piles of research showing time and again that one of the biggest investing mistakes people make is to buy and sell way too often. Even looking at your investments often is correlated to lower returns—it’s just too tempting to fiddle.
Timing the market is not easy. And think about it: you not only need to time when you buy, but also when you sell! We try to time the market and miss out. Or get scared by a big drop and sell our stock only to miss out on the bounce that often follows a few days later. Nearly all of the very best days to be invested in the stock market have been within days or weeks of the very worst ones.
Consider this:
J.P. Morgan Asset Management calculated that a $10,000 investment in an S&P 500 index fund would have been worth $32,421 if allowed to accumulate between 2000 and the end of 2019—a 20-year period that saw more than 5,000 trading days.
If you missed the 10 best days, it would leave you with $16,180, or just half as much—and that’s before paying capital-gains taxes! Missing the 20 best days would leave you with hardly any gain at all.
Warren Buffett’s “20-Slot” Rule
Warren Buffett is considered one the best stock pickers of all time. He’s like the Tom Brady of picking stocks!
When Warren lectures at business schools, he says, “I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.”
He says, “Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better.”