Investing is an inherently risky business, you only get to choose the amount of risk that you can afford to stomach. Low-risk investments will typically yield low returns, medium risk investments will yield medium returns, and high-risk investments will blow your mind with incredible returns. In contrast, when the market goes south, you’ll lose most of the money invested in high-risk investments and you might be able to recoup a large part of your initial investment in low-risk assets.
Now, if you are investing in stocks – putting all of your money in one great stock can provide you with enough gains to quit your job. On the contrary, investing all your money in the wrong stock can wreck you financially. Hence, professional portfolio managers often urge investors to avoid investment mistakes such as overexposure to a single stock.
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Many investors often ask whether it makes more sense to invest in a single stock that investing across multiple stocks. This piece provides insights into why investing in a single stock might or might not be the smartest investment move.
Here’s what happens with a concentrated investment strategy
The chart below suggests that you might be better off investing all or your money in single stock instead of spreading out your portfolio across multiple stocks.
In the chart above, the S&P 500, a stock market index, which represents the bulk of the market recorded gains of 76.54% in the last five years. In contrast, an investment the stock of Tesla Motors (NASDAQ:TSLA) would have gained 1,110% in the last five years. An investment in Facebook Inc (NASDAQ:FB) would have gained 752%. You could have booked 294.8% and 166.8% gains on the stocks of Amazon and Alphabet respectively.
Many high profile investors such as Warren Buffet believe that diversification is mostly “protection against ignorance. It makes very little sense for those who know what they’re doing.” Diversification reduces investment risks but it also tends to lower potential and accruable returns. Hence, sophisticated investors who can stomach high risks might want to build their portfolio around a few key assets instead of creating a basket of stocks akin to a mutual fund.
Here’s what happens in a diversified investment strategy
Diversification is simply a smart investing tool for reducing risk by limiting your exposure to any one stock or asset. A properly diversified portfolio will have a mix of cyclical, non –cyclical, income, and growth stocks among others. Cyclical stocks such as autos, airlines, and luxury goods tend to rise and fall in line with the prevailing economic trends. Non –cyclical stocks such as utilities and agriculture tend to rise in times of economic weakness. Growth stocks such as technology firms tend to record bursts of increases in value while income stocks tend to remain stable in the face of economic volatility.
A diversified investment strategy doesn’t always have to limit your potential for gains if you make education investment decisions. You should work towards creating a diversified portfolio in which each stock is big enough to have a material effect on the portfolio; yet, relatively small such that a 25% drop in its value won’t kill the portfolio.