all eggs in one baskey Posted by Christine of Small Investing Insights October 31, 2010

halloween – when else can you go up to complete strangers, say a few words and get free stuff. fine, you have to dress up, try to look scary (or cute) and fake fresh enthusiasm each time you shout “trick or treat”. but really, when else is it so easy to come by free loot?now as a grown up, i’m constantly being told “there are no free lunches” and so when it comes to investing, is there anything you can get for free?

i’ve often read that diversification is the only free lunch when it comes to investing. put your money in a basket of stuff (stocks, bonds, real estate, etc.) and this will lower the risk of your portfolio without lowering your expected return. by spreading your savings in a variety of assets which, in theory should not move up or down together, you’re reducing your risk of losing it all. the thing is, as 2008 has shown us, in a bear market the only thing that goes up is correlation.

but what if you put your eggs in a basket of high quality companies that can grow earnings over time? then you may find yourself with a free lunch if you invest for the long term. remember – a stock price represents the discounted sum of all the future earnings of that company. so if you invest in a business that is going to be successful over many years, as the business becomes stronger and more profitable, its stock price will rise to reflect the increasing earnings.

knowing what you own is practicing risk management and if you have the patience to invest in high quality companies for the long term, you may find yourself with a free may feel like losing your lunch as you ride out the stock market gyrations, but know that in the long term, investing in high quality businesses should lead to market outperformance. should you be looking for a quicker fix, then i suggest putting on a costume this halloween and start knocking on doors – it’s your one night a year to get something for nothing.