“You Shouldn’t Buy a Lottery Ticket”
It’s pretty straightforward, and most would agree it’s financially wise. But if you told someone who just won millions from the lottery that buying a ticket wasn’t a good decision, they might think you’re jealous or just don’t get it. Many might argue that purchasing that lottery ticket was the best financial decision the winner ever made.
Statistically, buying a lottery ticket or gambling isn’t a smart move. Dollars & Sense recently published an article about the odds of winning one of the biggest annual prizes, the TOTO Reunion Draw, which happens during Chinese New Year. The top prize is at least $5 million, but the odds of winning the TOTO Group 1 jackpot? About one in 14 million. Just because someone had a good outcome doesn’t change this fact. So, how does this relate to investing?
The Challenge of Diversifying Away Your “Winners”
One of our main challenges as advisers is getting clients to diversify out of their individual stock positions. These concentrated positions often come from stock compensation from their employers, leading to significant exposure to a single company’s stock. This is especially true among employees of successful companies where the stock has done really well or looks promising.
Since we serve affluent and high-net-worth clients, there’s some selection bias because Providend’s clients usually work for companies that are doing great. This success can make them feel secure and optimistic about the company’s future, making it hard for them to see the risks of holding a large, undiversified position in one stock. They might believe their company’s stock will keep outperforming, making them hesitant to diversify their portfolio.
What the Evidence Tells Us
The data is clear about the risks of owning individual stocks. According to Bessembinder’s study, only about 4% of all stocks have accounted for all the net gains in the US stock market since 1926. This means most stocks either matched the market’s performance or underperformed. In other words, while a few stocks have driven the market’s overall gains, most don’t provide exceptional returns, and many fail to keep up with the market or even lose value over time.
Looking at the top 10 companies in the S&P 500 over different 10-year periods show a lot of changes, with many companies dropping out of the top 10 because they didn’t perform well. Imagine working for these companies and relying on their stock performance during these times. Keep in mind, these top 10 companies got there because they were successful and probably well-run at that point in time. It really highlights how risky it can be to have too much invested in just one or a few stocks.
Source: The S&P 500
The companies that are on top today might not be there tomorrow, and if you’re heavily invested in them, you could be in for a rough ride if things go south. This is why it’s so important to diversify your investments. By spreading your money across different assets, you can protect yourself from the ups and downs of any single stock and increase your chances of steady, long-term growth.
A Problem of “Art” Rather Than “Science”?
The evidence and data are clear and have been for some time. This issue is more of an “art” problem rather than a “science” one. As Client Advisers, it’s our job to educate clients about these risks and the benefits of diversification. We need to help them understand that while their company’s stock may have done well in the past, relying too heavily on a single stock is risky. By diversifying their investments, they can protect their wealth and improve their chances of long-term financial success.
The challenge isn’t about understanding the data; it’s about overcoming the psychological barriers and emotional biases that affect decision-making. A big reason for this is the fear of missing out (FOMO) on potential gains if your company does exceptionally well.
Take an employee at Nvidia, for example. If they had diversified out of their stock position whenever they got stock-based compensation, they might regret it now, especially if their colleagues who held onto their stock are now multi-millionaires, ready to retire. This fear of missing out can be strong and can make people hold onto concentrated stock positions despite the risks.
However, just like how we don’t condone gambling or spending excessively on lottery tickets just because we heard of a few successful stories of lucky winners every year, we shouldn’t let rare success stories dictate our financial decisions. These exceptional cases are outliers and not the norm.
Conclusion
Making sound financial decisions, such as diversifying your investments, significantly increases the odds of success. Diversification helps manage risk and enhances the chances of achieving stable, long-term returns, even if it means potentially missing out on the rare, extraordinary gains of a single stock.
While a good outcome may feel rewarding in the moment, it doesn’t always mean the decision was the right one, especially when considering the risks and uncertainties involved. Though the lure of high rewards from concentrated positions is tempting, true money wisdom is to follow strategies that are statistically proven to boost the likelihood of financial success.
With over two decades of experience managing our clients’ hard-earned money, Providend has learnt that building long-term wealth is rooted in sound principles, not speculation. Instead of trying to “maximise returns” in a statistically losing game, our foremost priority is to help clients achieve sufficient investment returns so that they can comfortably and reliably meet their non-negotiable life goals and events.
This is an original article written by Isaac Ong, Client Adviser at Providend, the first fee-only wealth advisory firm in Southeast Asia and a leading wealth advisory firm in Asia.
For more related resources, check out:
1. Investing in the S&P 500 Alone is Not the Silver Bullet
2. Evidence-based Investing – Why Is It Important?
3. Why Evidence Based Investing Matters To You
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