Personal Investment Bible: Investment Iron Law Ⅵ

Investment Iron Law Ⅵ: Escaping the Trap of Locked-in Investments

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Don’t put all your eggs in one basket.

Diversification and Long-Term Holding

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Many investors often ask me: “Even if I believe that stocks and real estate have high returns and will rise in the long run, their prices fluctuate. Some investments will make a lot of money, while others will lose a lot of money. What should I invest in? What if the company I invest in goes bankrupt?” “When should I invest? What if I invest at the highest price point?” “When should I sell? What if I sell at the wrong time?” These questions reflect the risks inherent in investment and financial management.

Increase Returns, Reduce Risks

The eight-character mantra of investment and financial management is: Increase returns, reduce risks. The simplest way to increase returns is to invest assets in high-return instruments, such as stocks and real estate. However, high-return investments come with high risks. For example, stock and real estate prices fluctuate, leading to both profits and losses. Therefore, investors seeking high returns must bear the accompanying risks. However, these risks are generally undesirable for most investors. The correct financial management concept is not to avoid investment because of these risks. To achieve high returns, one should venture into investments with these risks, and then find ways to mitigate and minimize their impact.

Therefore, reducing risks to avoid losses and increasing returns to create wealth are equally important for successful financial management. The primary goal of risk management is to find ways to reduce the risk of loss while increasing investment returns.

Investing in high-return targets faces three main risks:

1. Choosing the wrong investment target.
2. Choosing the wrong investment timing.
3. Choosing the wrong selling timing.

So how can we reduce these risks?

1. Reduce the risk of choosing the wrong investment target - Diversify investment targets. 2. Reduce the risk of choosing the wrong investment timing - Diversify investment timing. 3. Reduce the risk of choosing the wrong selling timing - Long-term holding.

Reduce the Risk of Choosing the Wrong Investment Target - Diversify Investment Targets

A conglomerate that owned a private jet once required its CEO and second-in-command to attend an international conference simultaneously. The conference organizers held a cocktail party to welcome these two VIPs. Guests and media eagerly awaited their arrival. Amidst the cheers, only the second-in-command, who had arrived on a private jet, was present. The CEO was still at the international airport going through customs. It turned out that they had taken separate planes to mitigate risk. Indeed, with frequent air disasters, if they had taken the same flight and an accident occurred, it would have severely impacted the company.

Three thousand years ago, the Phoenicians invested heavily in building ships for international trade, venturing across the oceans. Successful voyages brought immense wealth; shipwrecks caused by hurricanes or typhoons resulted in total loss. Thus, the risks of overseas trade were enormous. A small group became incredibly wealthy through successful trade, while a few were ruined. However, the vast majority, fearing potential disasters, hesitated and missed out on substantial profits. Because few dared to take the risk, the limited supply of ships led to higher profits in maritime trade, benefiting those who invested.

Someone then devised an investment method that not only generated trade profits but also mitigated risks: diversification. The approach involved dividing the capital for one ship into ten parts, investing one-tenth in each of ten ships. This diversified the risk.

Despite precautions, on average, three out of ten invested ships would sink due to storms. However, the profits from the remaining seven ships not only covered the losses but also yielded substantial returns. Diversification reduced risk while maintaining the return rate. The possibility of all ten ships encountering mishaps still existed, but it was minimal, significantly lower than the risk of investing in a single ship.

The most effective and widely adopted method for risk reduction is “diversification.” Diversification simply means increasing the variety of investments. Mark Twain once said, “Don’t put all your eggs in one basket.” Distributing eggs across multiple baskets ensures that even if one basket falls, the remaining eggs are safe. This approach aims to reduce risk.

The investment environment is unpredictable and constantly changing. Fortuitous investments can yield high returns in the short term, but there’s also a high probability that chosen investments could plummet immediately after purchase. Most people avoid this risk by keeping their funds in risk-free instruments like bank deposits or government bonds. However, the correct investment perspective is to invest in “high-risk, high-expected return” targets to achieve high returns, while employing diversification to mitigate risks.

Invest in ten ships. Three sink. The remaining ones still generate profits.

Principles of Diversification

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The method of diversifying risk has been practiced for millennia. The principle of diversification was introduced in the “Portfolio Theory” published in 1950 by Dr. Harry Markowitz, the 1990 Nobel laureate in economics. Diversification means increasing the types of investments. For example, when buying stocks, don’t buy just one; divide the investment amount and purchase multiple stocks. With sufficient capital, diversify beyond stocks into real estate, gold, art, and other asset classes.

Increasing Investment Types Offsets Relative Risk

Diversification reduces risk because different investment targets don’t rise and fall in perfect unison. Even if they do, the magnitude of change varies. When several investments form a portfolio, the portfolio’s return is the weighted average of individual investments. Therefore, combining several high-return investments maintains high returns, while the portfolio’s risk is reduced as the fluctuations of individual investments offset each other. Increasing the variety of investments in a portfolio decreases the overall portfolio risk. This explains why diversification – increasing the types of investments – reduces risk.

Therefore, when investing in stocks, don’t just buy one type. Purchase several different stocks. Adequate diversification typically involves investing in ten or more stocks. For investors with limited funds who want diversification, mutual funds are recommended. Most mutual funds invest in 30 or more stocks, so investing $10,000 in a mutual fund is equivalent to buying more than 30 stocks, providing sufficient diversification.

Principles of Diversification

1. Choose Investment Targets with Greater Negative Correlation

The less synchronized the price movements of investments in a portfolio, or the more they move in opposite directions, the better the diversification. Choose investments whose price trends are inversely related to the existing portfolio. For example, gold is a good tool for diversification. Historically, gold has been a high-risk investment, but its price tends to move inversely to stock prices. During major international events like wars, political turmoil, or inflation, stock prices often fall while gold prices rise. Applying this principle to stock investment, choose stocks from different industries for better diversification.

2. Avoid Excessive Diversification

While working as a consultant at a securities firm, I observed a woman in the VIP room with papers scattered across the table, gesturing frantically as if commanding an army. Assuming she was a major investor, I discreetly inquired with a broker and discovered her total investment was around $300,000, spread across over 30 stocks. While aiming for diversification, she over-diversified, increasing management costs and diminishing returns. Excessive diversification is counterproductive. Even Warren Buffett, with his vast portfolio, invests in only about a dozen stocks.

Generally, increasing investment types reduces portfolio risk, but the risk reduction effect diminishes with each added type. Holding numerous investments for fun is acceptable, but if the goal is risk reduction, understand that the diversification effect diminishes with increasing variety. The difference in risk between holding 30 stocks and 20 stocks is negligible. Beyond a certain point, risk reduction plateaus, and further diversification offers no additional benefit.

Balance diversification against management costs. Diversification aims to reduce risk by increasing investment types across different instruments and targets. While increasing types reduces risk, it increases management costs as tracking multiple assets becomes complex.

Peter Lynch, in his book “One Up On Wall Street,” stated: “Investing in stocks is like having children – if you don’t have the ability to raise them, don’t have too many. No one says you have to invest in five or more stocks every time.”

Methods of Diversification

Diversification methods include various investment instruments, targets, and regions:

1. Diversification of Investment Instruments: Invest in different instruments, such as stocks, real estate, overseas mutual funds, art, and gold.

2. Diversification of Investment Targets: Invest in various targets. For example, when investing in stocks, don’t focus on just one. Spread funds across four or five or more stocks. Avoid concentrating on a few industries, as stocks within the same industry tend to move together. In real estate, if funds allow, invest in different property types like apartments, offices, shops, and studios, and diversify locations.

3. Diversification of Investment Regions: Diversify investments across different countries or regions. Some investors worry about concentrating assets in one region due to political, war, and exchange rate risks. Distributing assets geographically mitigates these risks.

Concentrated Investment Requires Confidence

Diversification reduces the likelihood of worst-case scenarios, but it also eliminates the possibility of the best-case scenarios. Full diversification makes extreme outcomes unlikely, resulting in returns close to the average.

Some argue for concentrating investments: “Put all your eggs in one basket and watch it carefully.” Admittedly, many successful investors concentrate their holdings. Few individuals are experts in both stocks and real estate. The choice between diversification and concentration depends on individual circumstances. If you’re proficient in a specific investment area, concentration might be preferable, offering potentially higher returns. For example, a real estate expert wouldn’t necessarily diversify into stocks. Over-diversification could have hindered their success.

If you lack confidence in most investment areas, diversification is recommended. While it might not yield exceptional returns, it protects against significant losses. Diversified returns are close to average returns. As long as the chosen investments tend to appreciate over the long term, like stocks and real estate, achieving average returns is sufficient for wealth building.

Mitigate the risk of incorrect investment timing by diversifying investment timing.

Diversifying Investment Timing

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Diversification applies to both investment targets and timing. To mitigate the risk of mistiming the market, distribute investments over time. Instead of investing a lump sum at once, divide it into portions and invest at different times.

Foolproof Method for Investment Timing

Two methods achieve diversified investment timing. The first is to invest whenever funds are available. A friend of mine invests $10,000 in stocks whenever his bank balance reaches $15,000, keeping his balance below $5,000. He also buys different stocks each time, diversifying both target and timing.

Another method is Dollar-Cost Averaging (DCA), which is regularly investing a fixed amount in mutual funds. Investors contribute a set amount at regular intervals (e.g., monthly, quarterly, or annually) at the prevailing net asset value (NAV). A specified amount is automatically deducted from a designated bank account on a specific date each month and invested in a pre-selected mutual fund. Since the investment amount is fixed, but the NAV fluctuates, the number of units purchased varies. This naturally leads to buying more units when prices are low and fewer when prices are high. Over the long term, DCA offers considerable returns and mitigates price fluctuation risks.

Reducing the Risk of Choosing the Wrong Selling Timing - Long-Term Holding

Long-term holding reduces the likelihood of losses. Choose long-term investment instead of being forced into it after becoming trapped.

Years ago, during training at Merrill Lynch, a securities analyst stated: “Statistically, the stock market rises 55% of the days and falls 45%. The problem is, we don’t know which days will be up.” The ratio of gains and losses in the Taiwan stock market is similar.

Therefore, if you, like the experts, don’t know whether the market will rise or fall tomorrow, the smartest approach is to guess it will rise. The more you guess, the higher your probability of being correct. If you consistently predict a market rise, the best strategy is: Buy whenever you have money, and hold. This seemingly simple approach is often the most effective. Many fortunes have been built this way.

Stocks and real estate are characterized by high returns and high risks. Due to their inherent risk, prices fluctuate in the short term, but their high returns generate a long-term upward trend. The longer the holding period, the lower the probability of loss. My research on the Taiwan stock market showed that the probability of gains and losses changes with the holding period, as shown below:

Relationship between Stock Holding Period and Probability of Gain

The table demonstrates that while stock prices fluctuate in the short term, the probability of loss decreases with longer holding periods. A one-day holding has a 45% chance of loss, which decreases to 40% for one month, 34% for one year, and a mere 1% for five years, making a loss almost impossible. Holding for ten years or more eliminates the possibility of loss entirely. Long-term holding not only reduces the likelihood of loss but is also crucial for increasing returns.

How can we build wealth from small investments? The key is the power of compounding, which requires both high returns and time. Investing in high-return instruments like stocks and real estate and holding them long-term allows compounding to work its magic, accelerating wealth growth. The longer the holding period (decades), the more apparent the high return rate becomes, and the investment loss risk rapidly decreases.

The goal of risk management isn’t to eliminate all risk, but to acknowledge its inevitable presence, understand it, analyze it, and then mitigate it. Never wait for absolute safety; it’s an illusion. High-expected return investments always carry risk, and no strategy can eliminate all risks.

Diversification reduces individual investment fluctuations, while long-term holding neutralizes short-term price swings. Investing in stocks and real estate requires accepting short-term and individual investment volatility. By diversifying and holding long-term, these risks are mitigated, reducing overall investment risk. In the long run, this strategy allows investors to benefit from the high returns offered by stocks and real estate.