Money Is Made from Single Positions and Kept with Diversity

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Money Is Made from Single Positions and Kept with Diversity

Money Is Made from Single Positions and Kept with Diversity

This is the way stock investing works in our imaginations: One startling insight and the courage to risk it all leads to an instant fortune. This is known to some as “hitting a home run” and to the less sports­minded as an act of sheer brilliance.

People believe in that one good pick because it’s celebrated both in the media and among friends swapping investment stories. Bill Gates is worth more than $60 billion because he founded Microsoft and because he owns a lot of Microsoft. Some of the richest people in the world started a company, guided it to prominence, and owned an awful lot of it along the way. Indeed, most of their net worth is paper net worth and just a reflection of the value of the companies they founded. If Bill Gates tried to suddenly turn all of his Microsoft stock into cash by selling shares on the open market, he certainly wouldn’t get $60 billion. His decision to liquidate his holdings would probably seriously impair Microsoft’s stock price.

Remember also that, for the most part, Gates didn’t buy his Microsoft stock on the open market. His holdings were awarded to him in exchange for his services in creating and guiding his company. Bill Gates, who started his company in a garage in Albuquerque, New Mexico, is the classic example of the entrepreneur who became wealthy. Glancing through the annual Forbes 400 list of richest Americans will yield yet more tales of folks who became wealthy based on their concentrated holdings in one company—usually companies they founded.

This lifestyle is not for everyone. The entrepreneur’s life is consumed by the businesses that they create. (There’s usually more than one, and usually a string of flops.) Though it’s tempting to want to “be your own boss,” most people would prefer to work for someone else who has to worry about payroll taxes, administering retirement plans, and cutting vacations short because a typhoon in southeast Asia delayed shipment of some vital widget that threatens the entire enterprise. An employee can keep life and work separate. Entrepreneurs can’t do that.

Another entrepreneur, second to Gates in terms of personal wealth, illustrates the value of diversified investing in the very structure of the company he controls. Sure, Warren Buffett is rich because he owns a lot of Berkshire Hathaway, but Buffett’s $30 billion net worth really arises from his decision to use Berkshire Hathaway to build a diverse stake of equity holdings that spans from Coca­Cola to the Mid­American Energy Company. Recently, Buffett even added junk bonds to his company’s growing list of investments.

Most investors simply aren’t home­run hitters. In the May 2002 issue of the Journal of Financial Planning, Mark Riepe of the Schwab Center for Investment Research tried to test how hard it is to hit a home run. He set up a computer program that, from January 1926 through December 1997 randomly purchased a stock every day and then tracked the return for one year against the market. He ran the program 75,000 times and found that, not surprisingly, the biggest winners won by huge margins but that they are rare. In the large­cap sector, 97.5 percent of the random picks produced losses worse than 50 percent. But 2.5 percent of those picks produced gains greater than 90 percent. In the mid­cap and small­cap sectors, 97.5 percent of the random picks lost more than 80 percent while 2.5 percent of them gained more than 150 percent.

Also, make no mistake, real wealth measured in millions of dollars arises from owning a lot of stock: A holder of a stock trading at $50 a share needs to own 100,000 shares to have a $5 million position. An already wealthy investor might be able to amass a large position in a company that will yet grow larger, but most investors aren’t threatening to take over board seats when they tell their brokers to establish a position. The average investor trying to become rich is best served by creating a diversified portfolio that can be monitored and occasionally retooled over the course of decades. In that way, stock splits, price appreciation, and the miracle of compounding returns will create wealth with relatively little risk.

If you’re one of the lucky few who did get rich off a home­run pick, don’t be afraid to diversify. The point to owning a lot of stocks is that they won’t all be going up or down at the same time. On the upside, that means that the losers will eat into the overall return a bit. On the downside, the winners will help to prevent catastrophic loss. Sometimes the market will rule and even a well­ diversified portfolio will move entirely in one direction or the other. But watch the financial report on the evening news on a day­to­day basis and you will constantly hear statements like “winners beat losers today by 3 to 2,” meaning that three stocks went up for every two that declined. Rarely, if ever, will you hear that “every stock went up.” That variety of individual stock performance is why diversification works.

It’s tempting to want to stick with a stock that’s paid off so well, but excessive exposure to one stock is always risky. Every year, people fall off of the Forbes 400, usually due to price swings on their major holdings. Martha Stewart, for example, was on the list in 2001 and then off it in 2002 after Martha Stewart Living Omnimedia lost 60 percent of its value. She’s no pauper, of course, but she might have protected her wealth through diversification.

As for the myth at hand, it’s true that concentrated positions sometimes make people wealthy. But either luck, exceptional skill, or special circumstances (being a company founder or an already wealthy investor) makes that happen, while diversification is still a proven tool for creating and preserving wealth in the long term.