Part 3: Where Investing in Stocks Gets Hard
In Part 2 we discussed how we expect that over the long term as businesses make money, the owners of those businesses (that is, the owners of the stock – investors like you!) should make money too. And that the same ideas of compound growth that you may be familiar with from savings accounts still apply to investing, though the growth each year isn’t known in advance and can vary.
Indeed, investment growth does vary widely and in some years may be negative.
Stocks Can Go Down, Too
We expect our investments to make money for us, but it doesn’t always work out that way. Accepting and understanding that risk is the most important thing to know before you get started with investing: you might lose money, and your plan has to account for what will happen if you do.
It’s also important to know because it’s where the returns above a safe savings account come from – you have to take risks to get higher returns (note though that the opposite is not true: there are risks with no potential reward attached).
There are many ways for those risks to manifest themselves. Some companies will simply run into trouble. Maybe they become obsolete as a new technology or competitor puts them out of business. I may have been BlackBerry’s last remaining fan, and even I finally made the transition to a phone from a more popular manufacturer this year. A number of retailers have fallen prey to Amazon and Walmart, and memories of Blockbuster Video may still be fresh in your mind. In some cases the underlying industry may still be going strong, but an individual company may fail. Up until the global pandemic the airline industry was still running strong, though its history is littered with the remains of bankrupt companies.
These examples seem like they may have been obvious in advance, but many of these – and many more that don’t immediately come to mind – are very hard to see and avoid. So the important lesson is to not put all of your eggs into one basket that might have a hole in the bottom.
Owning many different companies helps protect you against one or a few of them losing money or declining in value. We call a collection of investments a “portfolio”, a term you will hear a lot in investing – it just means the combination of stuff you own.
If you split your money evenly across 20 different stocks, then the most you can lose on any given one is 5% of your portfolio. That’s diversification, and as Warren Buffet puts it, it’s “protection against ignorance.” You can read every financial statement a company publishes and like what you see, but if they’re committing fraud then you can still lose money. Or a company may be really well positioned in their industry, only to have their industry decimated by a pandemic. Diversifying helps limit your losses.
Diversification is more than just spreading your investments over multiple companies: owning 20 different Canadian financial services companies clearly won’t protect you from very many kinds of surprises. So you will want to focus on reducing your exposure to many kinds of risk by spreading your investments across different industries and multiple countries.
The hope is that for the most part if one sector of the economy, or one country in the world goes into a recession that the others will not and your portfolio will still perform well for you (or at least not lose too much money). A goal of intelligent investing is to diversify broadly: owning investments that cover many companies in different industries and multiple countries.
Unfortunately the real world being what it is, there have been times when even that is not enough to protect you, as nearly everything goes down at the same time – the global financial crisis in 2008/9 for example, or more recently with the Covid-19 pandemic. So even with maximum diversification, investors still need to be prepared for their investments to go down from time to time.
Skewness and Diversification’s Upside
Another good reason to diversify broadly is that stock returns are not like many other things in life. Many things in our everyday experience have a so-called “normal” distribution, that famous bell curve you have likely seen many times. Whether it’s how tall people are, how big apples are in the grocery store, or how long you spend on hold with your bank, there’s an average in the middle, and some variation on either side, with not too many cases at the extremes.
Investing breaks that distribution: while at worst a stock can only fall to zero, a high-flyer can return much more than 100%.
Having a few stocks with super-high returns skews the distribution. These high-flyers are important to the overall market return, and missing out on them may mean under-performing. Studies have found that over various time periods, just a small handful of high-returning stocks have been responsible for the overall market’s out-performance of safer investments.
Identifying those out-performers in advance can be very challenging, however. In the classic investing book One Up on Wall Street Peter Lynch talked about these “multi-baggers” and how important they are for getting good performance. The book attempts to give clues on how to find such companies – famously boiled down to “buy what you know” – but in practice it’s extremely hard to match the performance of investing greats like Peter Lynch.
Which means that diversification serves a second purpose: not just to protect against ignorance and limit losses, but to ensure that you own many stocks to increase the odds of owning the few that will go on to provide abnormally high returns so that your average long-term return is acceptable.