Most investors put their money to work based on their expectations and opinions about the future. But what, if they are wrong?
There’s a problem with predicting what is going to happen because to a great extent the future is unknowable. The economy may be humming and then along comes an unforeseeable event like Saddam’s Kuwait invasion, 9/11, the collapse of Bear Stearns/Lehman Brothers or the Covid-19 pandemic that make financial markets tumble and destroys all your investment plans.
The issue with managing your investments based on your outlook for the future is you could be simply wrong. Investors with the strongest convictions tend to pay the biggest price. If you can accept two basic premises that,
1. the future is unknowable and
2. human beings are fallible
then it is clear what the smart, disciplined investor should do:
Spread their bets! (allocation and diversification)
You asset allocate to spread your risk among different types of equities (e.g. growth and value stocks, large and small cap stocks, foreign and domestic stocks), different types of fixed income investments (e.g. high-grade bonds, high-yield bonds, inflation-adjusted treasury bonds, all with different maturities), real estate, precious metals, cryptos and commodities among many other asset classes.
In addition to asset allocation, you can reduce your risk by diversifying within each asset class. You should a broader amount of different stocks, not just a few. Same for bonds and all the another asset classes. You can reduce your risk further by not investing more than 5% of your portfolio in any individual stocks to limit your risk of the overall portfolio when one specific investment sinks. Or run a percentage based trailing stop behind your individual investment. That way if you take the maximum loss on your maximum position size and your stock overall portfolio will lose just a fraction of the total value.
You can enjoy high returns when things go well and you are protected by your asset allocation, your diversification, your position-sizing strategy and your trailing stops, then individual assets or even markets occasionally tumble. We call this smart, disciplined investing. Best of all, this strategy is available to any investor and it does not cost anything.
Sven Franssen