As we find ourselves in the middle of the holiday season attending various holiday parties, family gatherings, ugly sweater contests, and open houses, invariably, conversation turns to the stock market. Perhaps an uncle took a bet in a hot internet stock that paid off and now fancies himself the chief investment advisor in the family. Or maybe your colleague lost a bundle in gold and is convinced everything is going down. Given the recent headlines, it’s probably safe to say that cryptocurrencies may come up at your next event.
It’s natural to feel like you have missed out if your buddy made a small fortune in Bitcoin while you were left on the sidelines holding a diversified portfolio. But with the recent precipitous drop in virtual currencies, it is also easy to see why maintaining a well-diversified portfolio makes the most sense. Taking significant positions in individual stocks can be risky, and these risks are compounded when the stock price is volatile. Losses are hard to take – not just emotionally, but in the context of reaching your financial goals. Consider this chart, which outlines the gain you need to break even on a loss:
When you’re down 40% on a stock, it’s easy to get into the mindset of holding it until you’re back to break-even; but as the math works out, you need to be up 67% just to get back to 0. It’s best to attempt to avoid these types of losses altogether, which involves taking a disciplined approach to investing and staying the course amid headlines touting the latest fad investment. While the history of bounce-backs in the broad equity market in the US is good, the history on individual companies is not. In fact, when comparing the list of companies on the Fortune 500 companies from 1955, only 60 companies were on the list at the end of last year. This means that 88% of these companies have gone bankrupt, merged, or fell in importance over time. Compare this to the compounded annual return on the S&P 500 over this period of 8.82% per year!
While the most obvious winners in your portfolio are the securities with the highest returns, it’s important to consider the investments that are “missing”. Avoiding the speculative investment in a small biotech company that is down over 70%, or even concentrated positions in bellwethers like Apple (down 25% from its YTD peak), can save you tremendous heartache and help you stay on track with your financial plan.
So the next time you run into an old friend at the hors d’oeuvre table who wants to tell you all about the latest and greatest new investment trend that you’re missing, you can be confident in knowing that managing your wealth for the long-term is a marathon that requires a disciplined plan of sticking to evidence-based investment principles tailored to your specific financial goals. Often this means avoiding taking large positions in popular securities that dominate the headlines. But it also means avoiding ending up on the wrong side of a trade.