You are going to make mistakes throughout your investment career; There’s no way to avoid it. Famed investor Peter Lynch once said that he’s doing just fine if he can hit six of 10 stock picks.
In other words, success means slightly beating a coin toss! The reality of investing is that it is very difficult. Sometimes you make a mistake, and sometimes an investment fails for reasons you couldn’t possibly see coming.
So why would anyone invest in individual stocks if the odds are stacked against them, and how do they succeed in the market? Roll up your sleeves because you’ll never “unsee” what I’m about to go through with you.
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Your winners matter more than your losers
Six out of 10 actions: how can you succeed in being wrong as well as right? People have the misconception that losers and winners have the same impact on their investment performance.
Suppose you buy a stock and the company goes bankrupt. The most you can lose is the money you originally invested, a 100% loss. But a stock can appreciate well beyond 100%, meaning a single winner can offset multiple losers.
Imagine you buy and hold 10 stocks for a decade. Of those, nine out of 10 shares go to zero. However, your 10th share goes up 1000% during that time. Having 90% of your stock picks at zero would be disastrous, however you would still be making money at the end of the decade because that winner outperformed all the losers.
The odds of choosing the “big”
With this in mind, an investor’s goal may be to find these winners, but how common are these exceptional stocks? Vanguard studied all the actions that were part of the Russell 3000 Index from 1987 to 2017. Roughly 47% of all stocks—nearly half—were “losers,” generating negative total returns over their lifetime. In fact, the total return on the median stock was only 7%!
Meanwhile, about 7% of stocks generated 1,000% or more in total returns. In other words, the index was a wasteland of bad stocks, with a small group of exceptional stocks generating the bulk of the stock index’s returns.
More swings at the plate create more hits
I’ve seen many investors talk about diversifying their investments as a defensive strategy, with the idea that great investment returns come from concentrating a portfolio around a few of an investor’s best ideas. But mathematically, the odds of a lackluster return might increase because they’re taking fewer “bites at the apple” to find those truly life-changing investments.
No matter how smart you are or how much research you do, investing will always have a bit of luck involved. Too many things can go wrong: misleading management, fraud, emerging competition, recessions, etc. Many of these are virtually impossible to predict.
But instead of a defensive tool, a diversified portfolio helps you achieve more advantage. Increases the number of “swings at the plate”, giving you better odds of hitting a home run. Remember, it only takes a few big winners to build a lifetime of wealth.
