No matter how thoroughly you research a company before you buy its stock, bad things can happen out of the blue.
Spread Out Your Bets
The reasoning is simple enough. If you put your proverbial eggs in multiple baskets, even if one or two baskets drop on the floor, the rest of your eggs would still be okay...
In real-world investing terms, this means investing in not just multiple stocks, but multiple sectors, and even multiple assets. For example, many financial advisors recommend the use of the standard 60/40 stock/bond split. I disagree with that split because I think that unless an investor is super conservative, he/she is better off in the long run investing in stocks instead of bonds, but the 60/40 rule of thumb is still in use today.
Diversifying can also help you make better decisions, especially if you have trouble keeping emotion out of your investment decisions.
The benefits of diversification in your portfolio should be self-evident. No matter how thoroughly you research a company before you buy its stock, bad things can happen out of the blue.
If a big chunk of your money is tied up in one stock, it will be hard not to get caught up in emotion and possibly make an impulsive decision you regret later. But if you’re only wagering, say, no more than 3% or 4% in any one stock, you’ll be more likely to make rational decisions and even sleep better at night.
Exchange-traded funds (ETFs) provide an easy way for investors to diversify. Instead of trying to pick a winner from a group of appealing companies, an investor can simply make a macro bet on the whole industry. Buying different ETFs that track different industries and assets will allow you to instantly diversify even more. It’s quite possible to bet on essentially the entire investable universe with a few dozen ETFs.
Getting the Bad with the Good
Spreading out your bets will limit your downside, but it will also limit your upside. When you buy an ETF, for instance, you get the bad with the good. Sometimes you may be better off buying shares in a select few companies than investing in the whole industry because not all companies in the same industry is the same, or even similar. For an example, let’s take a step back to 2020, when the outbreak of Covid-19 caused widespread social distancing mandates and lockdowns. Real estate investment trusts (REITs) were slammed because most REITs lease properties to businesses that figure to suffer a major slowdown in revenue due to social distancing mandates.
As a result, investors fear that REITs won’t be able to collect rent from tenants. However, at that time if you invested in cell tower REITs such as Castle Crown (NYSE: CCI) or American Tower (NYSE: AMT) and not a REIT ETF, you would have dodged a bullet.
Cell towers need no human patrons to make money. People staying at home still consume wireless data. Indeed, cellular usage surged during the stay-at-home order as businesses and individuals remain connected virtually.
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The chart shows the relative performance of CCI and AMT against both the S&P 500 and a Vanguard REIT ETF from February 19, 2020 (the market peak in early 2020) through April 17, 2020. Both CCI and AMT showed impressive protection against the coronavirus. While the S&P 500 fell about 15% over that period, both CCI and AMT were actually slightly in the green.
To be clear, lately CCI and AMT have both not performed well as a result of inflation and telecom companies (cell tower REITs’ customers) struggling under tight monetary conditions. However, despite the change in business conditions, the example of cell tower REITs being resistant to the pandemic outbreak still stands.
Pick the Best
While it’s easy to buy ETFs and call yourself diversified, often it’s preferable to diversify by investing in the best companies in each industry. The second approach certain takes more research, but it’s a worthwhile effort.
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