Why Do You Need to Practice the Margin of Safety/Diversification?
‘The only investors who shouldn’t diversify are those who are right 100% of the time’ – Sir John Templeton
The fields of trading and investing are quite different from most other professions. For example, if you are a novice boxer, there is NO chance you will ever beat Mike Tyson in his prime. Quite possible, but in practice, Mike Tyson would knock out any novice boxer 100 times out of 100 matches (probably within 60 seconds too).
In trading and investing, skilled professionals DO outperform amateurs, similarly to Mike Tyson. However, this outperformance is visible ONLY in the long run. In the short-term — several months to even several years complete amateurs can make true professionals look amateurish. Many of the risks associated with trading and investing are like Russian Roulette — the odds of losing are not that high, and if you keep winning for months, you will begin to discount that losing is even possible. But unfortunately, the bullet is always there — in the revolver.
One of the most significant errors people make is that they fail to diversify. There is an awareness that ‘Hey, for an insurance company to stay in business, it MUST diversify, but since I am not an insurance company, I don’t need to do it.’
The reality is quite different. A trader that fails to diversify consistently will most likely be taken out of business — surprises happen, earthquakes happen, companies get investigated, CEOs sometimes overreach, and investors/traders that don’t diversify consistently sooner or later are going to have to face a significant loss that could have been easily avoided had they been diversified.
This is a harsh lesson to learn. Partly because while in school and later on while investing/trading, we see examples of people who do successful single stock valuations, usually on CNBC. Those valuations sometimes turn remarkably correct, and nobody keeps track of their records. But if one starts keeping track of ALL forecasts of the major gurus, one will see the truth — NOBODY, or hardly anybody, can do consistent single stock future valuations! One of the fastest ways to leave the business is to start trading/investing in single stocks with high concentration!
Traders and investors think they have NOTHING in common with an insurance company, but that is an illusion. Don’t try to be a hero — always be diversified! As we say here at Alaric Securities — don’t forget that ‘Falling can feel like flying in the beginning!’