The simple answer is that i am attempting to go for excessive returns and have made the decision to take on the risk that one losing investment could wipe out a significant portion of my investments. My rationale being that even if I lost everything I have sufficient income to replace what is lost and sufficient time prior to retirement where i can still go back, replace losses, invest in a safer/diversified manner and end up with a sufficient amount to retire well. Without this I would never take on the levels of risk that I do.
What is Diversification?
Diversification is the process of spreading out your investments into various asset classes and sectors and spreading them among investments even within the same asset classes or sectors as well to ensure your portfolio is not subject to too much risk of loss from any one investment. The idea is to lessen the risk of one bad investment wiping out or depleting a significant portion of your assets. Diversification reduces risk (of exposure to significant loss from any one investment). Thus this increases your chances of having a successful long term investment returns as opposed to losses. Diversification is always recommended and is one of the bedrock financial principles that financial advisors will recommend. They do so for good reason. Most individuals don’t want to risk losing there entire portfolio from one bad investment and feel they could not recover from the same.
What is My Risk Tolerance?
People also have very different levels of risk tolerance (meaning the amount of ups and downs in the market they can handle). Some have very minimal risk tolerance (and would be extremely upset with any dip 1%, 3%, etc. Others, such as myself, can handle dips of as much as 20-30% or more without losing any sleep. Its not that I like the feeling of losing money, i just think about things differently. If I choose to invest in something, its because I believe in it and understand the risks involved. I know ahead of time what the possibilities are and what I am willing to risk. This makes me extremely comfortable. Yes, sometimes I get upset if things aren’t going my way, but i do not panic as I knew this was a possibility and don’t risk more than I’m willing to lose. What is your risk tolerance? This is something to think about before ever investing a dime. You don’t want your emotions throwing off your entire investment plan and causing you to make sudden and harsh decisions that could affect you for a long time to come. For example, within the last two years I owned over $100,000 worth of SWKS stock, and watched it dip down to $60/share from a high of $113/share. i held because this is a long term investment, which i want to grow over time. Had i panicked and sold at $60 I would have lost a good amount of money. instead, I held on, took my dividend in the meantime, bought more while it was lower, and still own these shares which again recently traded as high as $115/share and have paid another dividend since the big dip.
What Happens if I Don’t Diversify My Investments? At this point in my life I personally choose not to diversify my investments. I hold for periods of time, heavily concentrated positions with the belief and hope that the investments will go the way I want. This is a very risky proposition at times due to the heavy concentration where one bad investment could create a substantial loss for my overall portfolio. However, I am aware of these risks and yet i continue to do so….Why? i am not at the level of wealth I want to be at. i have used financial calculators and estimated how much wealth i could have in 30 years from putting away a certain amount each month and investing at the historical rate of return 7% of the stock market. In doing so, I have seen that this plan could net me a significant amount of long term wealth and I will have financial security, it results in quite a bit of money. However, this is not the story I have painted for myself and i am at a point in my life where I make a good amount of money and feel that I am willing to take on more risk of loss in the present (for at least a few years, as much as the next 5 years or so) to attempt to achieve higher than normal returns on my investments. Once i attain a certain level of wealth (if I am able to do so) I plan to allocate or diversify some to push more of the wealth toward a safer and less volatile method of wealth building.
To support my position on wealth building by going against traditional diversification advice, I must point out that one notable, famous investor, Warren Buffet who is considering one of the world’s premier investors, has for many years gone against traditional investment advice, sometimes having as few as a couple of investments with billions invested in each. Warren Buffet has also been confident in himself and his investments and their long term potential, never worrying about the ups and downs and only focusing on the value he saw in the underlying companies (basically indicating to ignore market fluctuations if you own a quality company and know there is value there, the value will eventually come through to the stock price). That being said, Warren Buffet is a smart guy and as a value investor, does not buy companies which are not solid financial investments. He has been known at this point to make some very shrewd deals, including getting government guarantees on his financial investments during the financial collapse around 9 years ago to invest in and support the rehabilitation of a large well known financial institution.
Examples of What Could Happen With and Without Diversification
To illustrate, mutual funds are typically considered to be diversified investments, although for true diversification you would need to invest across various asset classes to reduce risk of any one area harming your overall portfolio significantly. However, using the mutual fund example, let’s say a typical mutual fund in a great year makes 25%, with a downside risk of 15% tops. in a bull market, investor A buys $10,000 worth of a Mutual Fund and makes 25%, he then makes 15% the next year, and 20% the third year as the bull market rages on. He started with $10,000 and now has $17.250 after 3 years. Quite a return and he/she is extremely thrilled. As he was well diversified he was risking a downside of at most several thousand dollars a year and has achieved a significant return, almost doubling his money. Now let’s look at a more risky investor, Investor B buys $10,000 worth of GBTC the bitcoin ETF this year. This is an extremely volatile investment which some say will go to $0, others say will double this year. investor B gains 100% in year 1, gains 40% in year 2 and gains 50% in year 3 and ends up with $42,000. These are fairly extreme examples, but quite possible if one invests a substantial amount of money in one growth stock for a period of 3 years. However, the risk of losing the money for investor B is much greater as well. Growth stocks and GBTC for example, could lose value of as much as 80% or more in a matter of months or a year. If you took the example of investor B and had him/her lose 80% in year 2, the portfolio would have been down to $4,000 (even after being at $20,000 the year before) and only $6,000 at the end of year 3 despite having a 50% return that year. As you can see, more risk equals more potential for higher returns, but also more potential for higher losses. You have to be willing to lose money to invest that way.
My Risk Tolerance
I presently own a large stake in Skyworks Solutions over $100,000. Could it falter? yes. Could it go much higher? I believe so. Am I willing to take the risk? Yes, as i believe it is a good company in a good market with lots of growth potential and can withstand the ups and downs should the stock falter some. I strongly believe over time my investment will grow in value and this conviction keeps me able to withstand the ups and downs. Only time will tell how SWKS will do, but I believe it’s a good company and it’s balance sheet shows that it is a strong company with very little in the way of liabilities compared to the tremendous amount of assets on hand, including over a billion in cash.
Should you diversify? Typically yes, but this is a personal decision which depends upon your age, income, whether you can sufficiently replace any significant losses with time to recover enough prior to retirement to the point where taking on the extra risk at your current stage would not lead to complete and utter financial ruin for the rest of your life. I think everyone should take on some risk to be able to grow long term wealth, the only question is how much, and that depends upon many factors including risk tolerance, and the ability to replace lost income should things not turn out the way you want.