The following is a guest post from Demitrios from Sigma Swan. He is a new member of the Div-Net Network.
“If you take the whole history of Berkshire Hathaway, and you take out the 20 best transactions, our record is a joke.”
-Charlie Munger, Vice-Chairman of Berkshire Hathaway
We investors spend a lot of effort trying to protect ourselves from the danger of a default in our portfolio. The brutal math we aim to avoid is plain: the results of any string of positive numbers, no matter how long, when multiplied by a zero will always equal zero.
This is one of the organizing principles of capitalism, its original sin, you could say. There is no such thing as a free lunch. The flip side of return is risk or, in investment broker-speak, “equities are not FDIC insured and may decline in value.”
Beware the Zero
That unfortunate truth is the reason that we diversify, why we stick to our core competencies, anchor to index funds and blue chips, and “lighten up” – or avoid altogether – the high-flyers in a market. It is the reason we hold significant cash positions, tinker with our allocations, and worry about “black swans.”
These are all good tendencies. But, the temptation to get carried away with them is real, and every bit as hazardous to your wealth as frequent trading. Fear of the zero makes us do things like “limit exposure,” and “take money off the table.” It drives us out of equities and into treasury bonds, savings accounts, and commodities like gold and oil.
I Need a Hero
But while you are busy erecting a good defense for your portfolio, don’t forget that other equally powerful mathematic truth: an investment in a stock has limited downside but unlimited upside potential. The farthest a stock can fall is 100 percent, but the climb up the market-cap ladder is, in theory, limitless. And it is not at all confined to small caps. Apple (AAPL) gained over 100 billion in market cap in just the last two years, after starting from already mega-cap status of around 120 billion.
This slight upside bias is not just theoretically true, but is true in practice because U.S. stocks represent pieces of companies which can, and do raise prices over time. These companies are also part of the U.S. economy, which can, and does, grow over time. In general, higher prices and growing industries put upward pressure on profits, and that’s a good thing.
|Hercules fights the centaur|
What this means is that while investing carries an important, and serious, risk of default it is also true that a few good investments can be responsible for an outsized share of your portfolio’s performance. I know that’s true with my own portfolio, and I have seen it at work in Buffett’s performance, just like Charlie Munger said.
There is no substitute for having the right amount of protection built into your portfolio. And the degree of risk a person can take is a function of many things, including his or her age and risk tolerance. But the simple fact is that great performance has two mutually important pieces, and ignoring either one can mean catastrophe to your portfolio, whether it happens all at once or slowly over time.
Always aim to protect yourself from those zeros but be mindful of the fact that a handful of your greatest investments will be what really sends your portfolio into high performance territory.
Who are the heroes in your portfolio? How do you try to keep exposure to upside potential? How do you balance risk and return?
Full Disclosure: I own shares in AAPL.