When Investing, Everyone Thinks They’re Right!
If you watch any of the financial news channels or talk to any of those people who are considered the best in the financial world, one of the first things you will find is that everybody has an opinion and everybody feels that their way is the best way.
I believe that the reality is much different. While you will find a lot of people who are clearly not doing well, you will also find a lot of investors who are doing it right but who are using various approaches. While there are a lot of opinions, I can think of at least one truth that has no controversy: Use any legal investment strategy you would like but the object of the game is to make money and that is how you determine success. What works for you may not necessarily work for others but in the end what counts is that you actually grow your money using your approach. In the world of investing, how much profit you make is what matters (just as long as the means to your success is legitimate).
Boiling Down My Stock Investing Strategies Into 2 Rules
I’d like to share with you how I do my own investing; my strategies are pretty much rooted on the basic principles of long term investing that many (if not most) investors espouse:
Rule #1: Invest with your financial goals in mind.
First let me say that I have a full time job outside of the financial world, so I’m one of countless stock investing hobbyists who enjoys participating in the stock market on the side. My primary goal for investing is to build my retirement portfolio. I’m not looking to buy a private jet or a yacht in a few years nor am I looking to one day become a full time investor (at least, not anytime soon). My strategies revolve around who I am and what my goals are. Among the many stock investing tips that are out there, apply this one first: know who you are and why you’re investing. This doesn’t seem like it would be important but I assure you that it is. It will change the way you invest.
Image from ehow.com
Rule #2: Diversification rules!
If you could see how I invest, you may actually think that I’m overly conservative with my portfolio, and you would be partially correct with that assumption. The first thing I do is split up my money. For the sake of easy numbers, let’s assume that my portfolio has $10,000. (Don’t you get tired of reading those articles that give you all the best stock trading tips and investment advice for managing your $10 million dollars?) Often, when I help somebody set up a new portfolio, we start with a piece of paper upon which I draw 5 circles. This is where my “island theory” comes from.
My $10,000 has to be split into pieces. Pardon the analogy but I’m going to describe this as such: think of the pieces as 5 different islands (or buckets) that are far away from each other but in the same ocean. If a hurricane comes through and damages one island, the other islands are fine. Of course, because they are in the same ocean, they will all affect each other at least a little bit. So these are just basically different stock sectors or asset classes depending on how you decide to diversify. Each island (or diversification bucket) has to be different from the others.
My island theory is simply an analogy for stock diversification in the investing world. We should all diversify because it’s essential to managing our investment risk. This is the most important investing strategy that I follow. Don’t subscribe to information that says that you don’t need to diversify since it’s essential for protecting your assets.
So let’s take our $10,000 and split it into five parts. Each of our islands is going to have $2,000. We don’t have to be exact with our numbers but we have to be close: within $100 is my general rule. You can’t take from one island to help another.
Next, each island has to look different. One island can’t be made up of computer stocks and another island made up of telecom stocks. These are all technology stocks and only one island can be based around tech.
To get started, set up your islands and pick some of the best stocks that fit into these sets. So which stocks should you put in which groups? To work this out, you’ll need to read and learn about stock market technical analysis vs fundamental analysis, and don’t be afraid to use somebody else’s advice as a way to back up what you’re thinking. But don’t follow someone blindly either — you need to know why you own a stock.
Now allow me to go into specifics and discuss how I construct my “islands” (or buckets), and to talk about what else is involved when putting together an investment portfolio that is suited for the part time investor.
DIY Diversified Portfolio Example Using Individual Stocks
As mentioned, we’ll utilize $10,000 to purchase single stocks representing various sectors. How should we divvy up the $10,000 across the different investment “islands”? Following is my concrete example which shows the basic idea behind my individual stock portfolio — one that I’ve built with a good amount of thought, care and research. The following illustration shows how $10,000 is divided into five $2,000 portions:
Island 1 — The Financial Stocks: With only $2,000 to use, you’ll only have enough funds to purchase one or two stocks in this sector. Some examples to consider are JP Morgan Chase, Bank of America or Goldman Sachs (remember to review each stock’s underlying value).
Island 2 — The Tech Stocks: Check out Apple, Google, Hewlett Packard.
Island 3 — The Health Care Stocks: Look at Abbott Labs, Johnson and Johnson, Gilead.
Island 4 — The Energy Stocks: Some examples are Chevron, BP.
Island 5 — The Higher Risk Stocks: It may be a good idea to incorporate the stock of a small, up and coming company in your portfolio.
So basically, that’s the kind of diversification I do, in a nutshell. Many people achieve great results by simply investing in index funds or a target date mutual fund. But I prefer to diversify this way, by fully controlling my portfolio and picking my own stocks. Note that this is just a hypothetical set up. To be honest, this example is quite simplistic because the true benefits of diversification are best met through investments that are as uncorrelated as possible. So while it’s a good idea to diversify among stock sectors, you can easily achieve this type of diversification by purchasing an index fund or general mutual fund. But for better diversification, you should actually buy mutual funds that represent various asset classes (e.g. a domestic stock fund vs a foreign stock fund vs a bond fund and some cash).
Created August 27, 2009. Updated April 12, 2012. Copyright © 2012 The Digerati Life. All Rights Reserved.
{ 15 comments… read them below or add one }
Knowing investment goals is so important. Many people chase after the best returns and in the process add a lot of risk. Knowing when you need the money and how important it is to preserve the capital goes a long way in developing a good investing plan.
Hi Tim, You are right. Everyone says that they are correct about investing. I think, actually the person doesn’t want to tell their solution because of fear that if the secret leaks, all will use. I understand your strategy of investment. Well, your island theory fits in my mind, i’ll see if I can put it to use.
I like these two rules. #1: It is always good to ask, “Why am I doing this?” before you invest or before you do anything else for that matter. #2: Diversification is good, too. While you spend the time and while you may have the skill to select good stocks, many people have neither one. That is why funds – but not just index funds, target funds, or ETFs – have become so popular. Investors get to buy into a diversified portfolio if they put their money into a fund. Also, if you do diversify the portfolio yourself, keep in mind that studies have shown you need about 20 different stocks to achieve good diversification.
Diversification is certainly of critical importance. The problem is that our knowledge of what constitutes effective diversification is greatly limited today and too many “experts” are reluctant to acknowledge this.
How many times have you heard the “experts” say that you need to increase your cash allocation to achieve effective diversification? “Experts” hate cash because they earn no commissions when we invest in it. But at times of insanely high stock valuations cash can be the best long-term investment class.
And how about your career? Should that count in your diversification analysis? I think it should. If you are in a high-risk/high-reward career, you should take a safer path with your investments. If you have a safe job, you can afford to take on more risk.
Rob
This is cool. i read a book that said that you must not put all your eggs in many baskets but put them in one basket and then watch it really closely(i think that it is warren buffett that said that) but i am still contending with that. one of the reasons that diversification is good particularly for new investors is because one gets to learn a lot from the mistakes made, which is better than being rigidly stuck at one point.
I noticed all your investments were stocks. Do you own bonds? Commodities such as gold or silver?
I would suggest that a diversification strategy that is based entirely on stocks does not adequately create a portfolio that is sufficiently non-correlated. Thats a big mouthful for – If all the islands are in the same ocean, they can all be hammered by the same hurricane.
I would suggest looking to move some islands to another ocean or maybe even a mountain top 🙂
Great visual though on the diversification.
Hello,
I really enjoyed this website. Its great to see people helping others with a very real issue- smart investing for a secure future. If we share and educate each other we can empower ourselves to achieve financial security and independence. I encourage you to check out my blog on the subject of stock investing so we can continue to create a helpful community of like-minded individuals:
Kurt’s Stock Strategy Blog
Unfortunately I was not very strong in matters of investment, but one thing I learned in life: – Do not invest all your money into one project, you should always separate them into several parts, creating a “Investment portfolio”, when doing so reduces the risk of loss!
The subject of diversification is often too restricted to different stock groups. But buying different stock groups isn’t true diversification because most groups move in similar directions during big market moves.
True diversification in involves fixed assets and possibly even commodities. But the only type of diversification you hear coming out of the financial crowd are different kinds of stocks. No wonder so many people were hit so hard in the recent market slide!
@Scott,
Not sure what Tim, the guest contributor, has for his portfolio, but mine is pretty diversified with bonds, cash, real estate. I still have to get a little of the precious metals in there. And am adding more “personal loans” via Lending Club notes. 🙂
Good tips, I would consider Wells Fargo in the financial sector. See my 12 stocks for 10 years portfolio. Since April of 2005 it has outperformed the S&P 500 by 4.5% (as tracked by marketocracy which subtracts 2% a year from the portfolio returns to simulate management fees). Google is the largest holding.
It appears from comments that no one appears to have any real direction in regards to investment strategies. I would suggest, get and stay in mutual funds invested in the best performing sectors of the global market place.
I think diversification is appropriate when investing in the market but it is necessary to understand the conceptual and practical correlation that exists with trading options and diversifying strategies.
Diversification as indicated in this article points out how to invest in more than one holding. But it has a bigger dimension than this; to make your trades diversified you should keep a check on the trade portfolio and see that it consists of conservative and high-risk investment trading options in appropriate proportions.
In order to diversify your trade moves, proper market research and analysis should be done to find out the exact drivers that influence the particular trading option.
Great post discussing diversification, Tim.
I wanted to just follow up on comments a couple of other posters have made about diversification.
Your strategy of diversification reduce unsystematic risks, those facing one particular company or stock.
Thanks again!
Systematic risks are risks that face an entire sector or economy. Using your strategy, if the US stock market tanks, most stocks will follow (although in varying degrees and time frames). Diversification needs to also encompass these additional risks.
Here is a good article from investopedia on the topic:
http://www.investopedia.com/university/risk/risk2.asp#axzz1sye3ZQdm
@Joseph,
Thanks for pointing out the need to address other forms of risk as well. Personally, I go for risk minimization across assets and even through possible eventualities. For example, understanding how inflation, deflation, stagflation, high growth vs lower growth economic scenarios can help, along with arming oneself with an “all weather” portfolio that addresses these diverse scenarios. But even that may not be sufficient to protect an investor with *anything* that can happen. You can only do your best to “cover all the bases”, but doing so will result in tradeoffs, no matter what.
This is the case because risk and return go hand in hand and by trying to minimize risk, you will inadvertently affect returns as well. A wise investment advisor once told me that the best bet is to grow your portfolio when you are young, then when you reach a certain asset base, move to preserve and conserve what you already have. If you’re going to aim for wealth conservation, then you may want to find other ways to build your wealth beyond investments (say via work/business) and then make sure that your portfolio takes a more defensive stance.