Five Key Concepts to Investment Success
While investing can, at times, seem overwhelming, the academic research can be broken down into what we call the Five Key Concepts to Investment Success. If you examine your own life, you'll find that it is the simpler things that consistently work. Successful investing is no different. However, it is easy to have our attention drawn to the wrong issues. These wrong issues can derail our journey as we attempt to achieve all that is important to us. In this section, we'll walk through these five concepts and then explain how successful institutional investors incorporate each of these concepts into their investment plans, no matter which direction the markets are going at the moment.
Concept One: Utilize Diversification Effectively to Reduce Risk
Most people understand the basic concept of diversification: Don't put all your eggs in one basket. However, no matter how sophisticated you are, it's easy to get caught in a trap.
For example, many investors had a large part of their investment capital in their employer's stock during the recent downturn. Even though they understood that they were probably taking too much risk, they didn't do anything about it. They justified holding the position because of the large capital gains tax they would have to pay if they sold. Often, investors are so close to a particular stock that they develop a false sense of comfort.
Other investors believe that they have effectively diversified because they hold a number of different stocks. They don't realize that they are in for an emotional roller-coaster ride if these investments share similar risk factors by belonging to the same industry group or asset class. "Diversification" among many high-tech companies is not diversification at all.
To help you understand the emotions of investing and why most investors systematically make the wrong decisions, let's look for a moment at what happens when you get a hot tip on a stock. (See Exhibit 2.)
If you're like most investors, you don't buy the stock right away. You've probably had the experience of losing money on an investment—
and did not enjoy the experience—so you're not going to race out and buy that stock based on a hot tip from a friend or business associate right away. You're going to follow it awhile to see how it does. Let's assume, for this example, that it starts trending upwards.
You'll watch it a little longer to see how it does. Howdo you feel? You hope that this might be the one investment that helps you make a lot of money. Let's say it continues its upward trend. You start feeling a new emotion as you begin to consider that this just might be the one. What is the new emotion? It's greed. You decideto buy the stock that day.
You know what happens next. Of course, soon after you buy it, the stock starts to go down, and you feel a new combination of emotions—fear and regret. You're afraid you made a terrible mistake. You promise yourself that if the stock just goes back up to where you bought it, you will never buy like this again. You don't want to have to tell your spouse or significant other about it. You don't care about making money anymore. Now let's say the stock continues to go down. You find yourself with a newemotion. What is it? It's panic. You sell the stock. And what happens next? New information comes out and the stock races to an all-time high.
We're all poorly wired for investing. Emotions are powerful forces that cause you to do exactly the opposite of what you should do. That is, your emotions lead you to buy high and sell low. If you do that over a long period of time, you'll cause serious damage to not just your portfolio, but more importantly, to all your financial dreams.
