In my previous post, I talked about the risk of investing crossing over into gambling; diversification is one of the best ways to prevent that from happening.
Gambling is all about putting all your eggs in one basket, betting the pot on one result, whereas diversification is about spreading the risk so that if one investment goes sour, you have other investments in other areas that can cover the loss.
One of the main keys to successful investing in starting with the end in mind. What I mean by that is, strong and successful investors know before they begin, what the outcome is that they want to achieve. If the aim is to create an income for retirement then the fund will need to be made up of the safer assets available, like bonds, property and cash, funds that have a low loss rate. If the aim is to generate income now, or your preference is a higher risk, then stocks, options and futures etc will be a better fit.
Whatever the preference, remit or style of your investing, the key is to know what you want to do before starting, and then ensuring you don’t invest in just one area.
But let me explain why diversification when investing is important.
Let’s say you were to put all your money into property development. This is something a lot of people did pre 2008 and when the housing market collapsed, their investments disappeared. Or imagine if your portfolio is made up only of stocks in the oil industry, with the price of oil continuing to fall right now, your portfolio would be looking rather depleated with no view of a recovery in sight. But if you had some of your portfolio in oil and some in renewable energy, then when one is down, the other prevents you from losing everything.
The best type of investment diversification is spreading your investments across a multitude of investment types and industries. So if you go for a mix of stocks and mutual funds or ETF’s then also diversify further by spreading them across different industry types like construction, transport, health sector and so on.
Diversification is the best way to protect yourself from mass loss. It is not a completely fool proof way, nothing is, but the more your diversify by putting your investments in many baskets compared to putting all your money in one basket, the more you protect yourself when one basket is hit. Every person I have ever coached, worked with or talked to who lost everything, did so because they put everything into just one or two investments. Everyone who I speak to who has diversified their investments suffers the odd loss now and again, but I never see them panic, because they have that safety net that is diversification, in place.
There are a lot of people who invest, who will tell you that investing is nothing like gambling, that gambling has everything to do with luck only and investing is all about reading the markets and making decisions off data, or it’s investing in an a fund that does guarantee a return over time, something gambling can never do.
Although this is true, it is only to an extent. There is an occasion when investing becomes gambling and any so-called guarantees that an individual was hanging their investments on, goes out of the window.
To understand this let me explain the premise of gambling. Gambling is all about betting on one thing happening over another. Whether it’s betting on black over red, one horse over all the others, The Yankees over the Red Sox, or even your stock going up and others going down, gambling is about betting on something specific happening. Take a coin toss for example. You toss a coin and you call tails, but it comes up heads, so you call it again, and again it comes up heads. The odds of it coming up heads a third time are now even greater, so therefore, the chance it will land on tails has increased and so you now bet $10 on the coin landing tails. Having placed your bet, you toss the coin and it lands on heads again. OK, the next toss has to land on tails, so you double your stake, toss the coin and it comes up heads a fourth time. You go through this process ten times, each time doubling your stake and each time losing. That original $10 bet is now a $20,000 plus loss.
This is where gambling and investing cross over. A leading investment expert goes on MNBC or Bloomberg and says that the market is going to go down. Right now there is a lot of chatter that we are potentially moving towards a bear market, but on what basis is that statement made? It is purely made on the direction the market took last month. As a result of the statement made, people then adjust their investments to be in line with a bear market, but making statements purely because the previous month was down, is no different from saying the coin has to land on tails this time because the last 6 were all heads.
History cannot tell us how something is going to turn out, it only tells us what happened. So just because you had a certain number of months of negative results, doesn’t mean that it is going to continue for another three or four months, but neither can you say that because we have had 3 months of negative results we are bound to have good ones now because the same thing happened in ‘1990 whenever.’
Investing is about reading the here and now, not hoping that it will turn or that history will repeat its self. Having that mindset leads to being overly confident – a ‘one day it’s going to turn it has to’ attitude, and all the time you are increasing your investment with the view, your luck has to change soon and you will recoup those losses.
Unfortunately, that is not how it works and like many gamblers who walk away from the table full of regret and remorse, so do investors if they allow investing to cross over into gambling.