If you’ve read my book on wealth, you know that I highly discourage trying to time the stock market or to cherrypick which stock to buy. In today’s stock market, we have another great example of why. The market overall has been wobbly, with a few stocks (Facebook, Google, Amazon) shooting into the stratosphere and the rest of the market essentially in recession-level pricing (especially the energy and industrial sectors). This is great if you have concentrated your wealth correctly in those few stocks that are doing well, but most people didn’t guess right and are instead dealing with huge portfolio losses.
Let’s illustrate this point with a simple example. Assume a stock market with four different stocks.
- A has dropped by 20% in the past year
- B has dropped by 25% in the past year
- C has gained by 150% in the past year
- D has dropped by 10% in the past year
Assuming that each stock is weighted equally in the market, this means that the entire stock market as a whole has increased by 23.75%, all on the back of stock C.
Now we have fifteen different people each with a different approach to the stock market, scattered on the spectrum between concentration and diversification. We also list their gains. For math/stats geeks, we are essentially enumerating all the possible combinations of choosing among four options.
- Person 1 concentrates all wealth in stock A (-20%)
- Person 2 concentrates all wealth in stock B (-25%)
- Person 3 concentrates all wealth in stock C (+150%)
- Person 4 concentrates all wealth in stock D (-10%)
- Person 5 buys two stocks (A and B) (-22.5%)
- Person 6 buys two stocks (A and C) (+65%)
- Person 7 buys two stocks (A and D) (-15%)
- Person 8 buys two stocks (B and C) (+62.5%)
- Person 9 buys two stocks (B and D) (-17.5%)
- Person 10 buys two stocks (C and D) (+70%)
- Person 11 buys three stocks (A, B, and C) (+35%)
- Person 12 buys three stocks (A, B, and D) (-18.33%)
- Person 13 buys three stocks (A, C, and D) (+40%)
- Person 14 buys three stocks (B, C, and D) (+38.34%)
- Person 15 is the closet indexer and buys all four stocks equally (+23.75%)
In short, the more stocks you buy, the closer you get to the index average and thus are more likely to get a positive return. The fewer stocks you buy, the greater the chances of scoring a home run hit, but with a greater chance of losing money as well. The effect is magnified even more when only 3/500 stocks in the S&P index are outperforming the index. This example illustrates the value of diversification. In a world where most of the gains come from a few stocks, and where most of the gains come on a few days, missing out on those days or those stocks can be catastrophic for the overall portfolio. This should serve as yet another point in why low-cost index funds, with their instant diversification, are the only correct way to invest in the market.