Many people have asked me over the years “Why diversify? Why not buy just your best one or two stock ideas and hold those”. It’s a good question, and an important one.
Here is the truth about stock investing. If we buy ten stocks, what’s going to happen over time is that two will be lousy stocks, six will be just okay, and two will be big winners. You might scratch your head at that and ask how it’s possible to make any money. The profit comes because a stock can at worst lose 100% (let’s hope not!) but it can go up 300%, 400% or more. Out of ten stocks, eight are either dogs or average. But the two superstars pay for everything. They are the source of the extra profits.
There are two important lessons here. First, if we buy one stock, we have eight chances in ten that it will be average or worse. But if we buy ten good stocks, odds are we’ll have a couple of those real gems. This is mistake I see constantly. Someone buys a mutual fund, but they also have one or two stocks that Uncle Murray recommended. Not the best idea. If we’re going to buy individual stocks, we should buy at least ten, not one or two. Second, some people advocate selling a stock after it’s gone up 100%. But if we do that, we’ll never have our big winners. If we want to make any real money, we need to hang onto our winners. Hang on as long as the valuations aren’t silly of course.
So we come back to two of our boring themes. Buy a diversified portfolio of stocks and hang on tight. And if we do, we’ll have a very good shot at owning those two out of ten.