Last week, I gave you my take on why stock picking is still something I recommend to those who are willing to do the work and take a long-term approach. On the other hand, index investing is a sure way to beat most mutual funds without any effort at all. This week, I’d like to discuss two more important concepts: Risk management and timing your purchases.
People often tell me I invest in risky stocks, which is absolutely true. Tesla Motors, which I hold in my personal portfolio, is competing against General Motors, Ford Motor Co. and every other major car company. Will they succeed in selling electric cars where every other pure-electric car company has failed? I think they will, but there is no debating the high-risk nature of the stock.
Yet when most people speak of risk, they really mean stock price volatility. The two are not the same. Risk is, in my mind, business risk. When I say business risk, I’m talking about longer-term growth and profitability. Volatility is short-term stock market valuation risk. I’ll come back to this later because it matters when making regular investments in your financial future.
Investing everything you own in Apple, Amazon.com, or any of my other Strategy Lab picks would be highly risky. I doubt any of you would argue with me on that point. But an entire portfolio of risky stocks is much less risky than betting it all on one stock. Instead of investing in one company, I place many bets on many companies that I consider to be leaders in important, emerging industries. Some of these bets go south. I’m fine with this because other bets will deliver strong returns.
Let’s look at how this same principle applies to businesses. Let’s look at Big Pharma. I know very little about the complex chemistry of inventing new pills to treat various health problems. But I do know that drug discovery projects are expensive, lengthy and have a high probability of failure. If the project fails, the investment returns nothing. If the project succeeds, we might have the next big pill that doctors everywhere prescribe to a population that largely prefers pills over a healthy lifestyle. Whatever your opinion on our health care industry, Big Pharma can be a money-printing machine.
Big drug companies succeed in business by investing in a large portfolio of projects. To bet their entire future on only one drug would be too risky. Connecting the dots back to investing, it’s quite clear that a portfolio of stocks is going to yield some winners and losers. With a portfolio of stocks, your money is much safer.
Now let’s talk about how to implement this in real life, such that you benefit from diversification and stock price volatility. It’s no secret that Wall Street has a short-term focus. Stocks swing wildly based on the collective emotional state of investors, often driven by minor differences between quarterly earnings and analyst estimates. When you see a major swing in a stock, stop and ask yourself whether the news that drove the swing matters in the long term. All too often, I find that the news is disconnected from long-term business performance.
If you are interested in picking your own stocks, I recommend you assemble your own wish list. Ideally, by saving money and making regular monthly contributions to your portfolio, you can build up your holdings over time. When it comes time to make your monthly investment, you can look at your wish list and see what’s on sale. Sometimes, everything is on sale. Sometimes, everything is more expensive. But often, one of your wish-list stocks will represent a bargain. You can buy your wish-list stocks in small chunks over time as you save.
Is this market timing? No more so than stocking up on coffee beans when Costco has a promotion or waiting for that pair of jeans to go on sale at the Gap. You’re thinking about investing, not selling. You’re looking for great entry points rather than searching for the next likely pop in a stock to make a few bucks.
By the way, this strategy is not limited to growth stocks. You can apply the same philosophy to dividend investing, value investing or index investing. It’s really quite simple. Know what you want to own, and then buy when Wall Street hangs a discount sign in the window. Good-quality businesses don’t stay on sale forever, but they all go on sale, and it happens more often than you may realize.
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