Early in his career, the individual seeking to be financially independent would be living on less than he made and putting money away regularly for investing. Because he had relatively little to invest, he had little to lose. This, combined with a long time horizon that allowed for recovery from mistakes and just plain-old bad luck meant that he could be aggressive with his stock investment. He would also be putting money away regularly in his work’s 401K plan and perhaps a personal IRA on the side. This would ensure that even if his investments didn’t work out he would still have a retirement equivalent to his peers – better than most, in fact, since many of his peers would not contribute to their 401K’s and IRAs or cash them out at some point in their lives once the balance started building up.
Being aggressive did not mean being foolish. He would still invest in a way that would put the odds in his favor. This included investing for the long-term where growth in stock price could be expected to follow the growth in intrinsic value of the stock he was buying. Likewise, he would be buying shares only in companies with steady earnings growth, good management, and room for continued growth. He wouldn’t be trying to time the market or playing various games since he knew that those games were stacked against him.
The risk he would be taking was concentrating his holdings in a few great stocks rather than spreading his money out over several stocks or buying an index fund or mutual fund and just accepting market returns. He would be concentrating his investments in a few companies that he believed would outperform their peers over the long-term. Because bad things happen to even good companies — officers steal money or cook the books, new regulations are created that hamper the business, competition emerges that takes a large amount of the company’s market share, or they drill a hole in the bottom of the ocean and kill everything in the area he would be taking the risk that one of his selections could decline substantially in value. The price of the shares of any individual company can decrease rapidly or even become worthless in a short amount of time.
Likewise, while the entire market does not increase in value that rapidly, averaging about 10% per year, it is not that uncommon for individual stocks to double or even quadruple in the period of a year. If one is fairly good at picking stocks, one can therefore make up for one or two bad stocks that go nowhere or even disappear with one great stock that goes up twenty-fold over a period of 10-20 years. In the early stages, our young investor is trying to find one of these stocks to make his meager holding grow rapidly.
As this investor continues to buy shares, however, he should reach a point where he does start to have enough money to begin to protect it. In his personal investment account, he may have 5 of 6 large positions worth about $10,000-$20,000 each, with an account balance of fifty to one hundred thousand dollars. (Note, he should also have a like amount in a 401k, which would be invested in an array of mutual funds.) At that point he should start diversifying his holdings to reduce risk. As stated before, diversification reduces risk because holding a basket of stocks or other investments reduces the damage done by the collapse of any one asset and the advances by some stocks in the portfolio will offset the losses by other stocks.
The amount of security depends on two factors: 1) The number of different positions held, up to a limit of about 50-100 stocks, at which point further diversification has little effect, and 2) the amount of covariance among the holdings.
To achieve a larger number of positions, the easiest method is to take a portion of the portfolio and put it into mutual funds. Because their costs are lower and they perform as well as managed funds, index funds are a good choice. One way of determining the amount of your funds to put into index funds is to simply use your age. If you are forty, you should have about 40% of your funds in diversified mutual funds. When you are sixty, you should have about 60% of your funds diversified into mutual funds (with about 5 years’ worth of expenses in cash as well).
The covariance is a factor that determines how the different assets you hold tend to move in the same direction. Two holdings with a covariance of 1 would move in lock-step. This would mean that holding these two holdings would offer no more diversification than putting all of your money in one of them. An example of two assets with a covariance near one would be an S&P500 fund offered by American Funds and another offered by Vanguard. Except for differences in fees, these two funds should move in concert with each other.
Likewise, two investments with a covariance of zero would move with no relationship. An example here might be investments in the housing market in France and one in Washington DC. While it is possible some global event might affect both markets, in general the changes in price between the two investments would be fully uncorrelated.
Finally, two investments with a covariance of -1 would move in exactly opposite directions, where one would go down 10% if the other went up 10%. An example of would be a call option and a put option on the same stock at the same strike price. Because the call option would become more valuable if the underlying stock went up, while the put option would be come less valuable, they would move almost directly opposite to each other.
Ideally, covariance should be about zero among the various holdings in a well diversified portfolio. To achieve a portfolio of assets with low covariance, buy funds in different asset categories. For example, buy a large cap fund, a small cap fund, a bond fund, an international stock fund, and a real estate fund (REIT). One could also toss in a commodities fund in small amounts if inflation was a concern. Buy some funds that pay a large dividend (ideally hold these in an IRA to protect yourself from taxes) and buy others that pay almost no dividend but hold a large number of growth stocks. You can also select managed funds that try to buy based on value (an example would be a “Dogs of the Dow” fund ) and another that invests based on momentum.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.