Many success stories tend to focus heavily on those “rags-to-riches” stories—those astute persons who amassed their fortunes by making highly concentrated business investments. Entrepreneurs such as Ken Langone of Home Depot and Jeff Bezos of Amazon fame have become incredibly wealthy by focusing all their time, energy, and capital into one single company. While these titans of business evoke our curiosity and perhaps admiration, most investors would be better served to stick with tried and true principles of diversification and downside risk management when investing their wealth for accumulation or preservation. Why is this? Because the upside opportunity does not justify the downside risk that we become exposed to when making highly concentrated investments.
Many of the billionaires on the Forbes 400 list have achieved that level of wealth by making highly focused investments. What may not be as evident is the survivorship bias that is inherent in these amazing stories of wealth accumulation. For every entrepreneur that became highly successful, how many failed? According to Forbes, about 2 out of 3 businesses fail with the first 10 years of their existence. For every success, there are twice as many that have failed to meet their lofty dreams and expectations, some even after several attempts. The allure of a fabulous opportunity can cause many to underestimate the downside risk and the potentially devasting consequences.
When it comes to investing, a diversified portfolio will always underperform some individual investments during a given year. This is difficult for some investors to come to grips with; people tend to tout their investment successes far and wide, and we can start to experience a “fear of missing out.” However, a properly diversified investment will also outperform the poorest investments as well, and that is what is so important.
It is not uncommon for some individual investments to be up +100% or more in a given year, but there will also be some large losers as well. While a +70% upside return from an individual investment may look attractive, a -70% loss requires a +233% return just to get back to even. A loss of this magnitude can be devasting to a long-term financial plan and can take years to recover.
Working with an advisor to establish a long-term financial plan and stay allocated to a smartly diversified portfolio will minimize the impact that any one poor investment has on your investment portfolio.
Our goal is for investors to own enough of the winners to grow their investments steadily over time, but not enough of the losers to sabotage their financial goals.*
*Diversification cannot assure success or protect against loss in periods of declining values.