Study great investors like Peter Lynch and Sir John Templeton and you will likely notice how they often try and diversify when they invest. During his short-but-glorious career managing the U.S.-based Fidelity Magellan fund from 1977 to 1990, Lynch had famously held more than 1000 companies in his portfolio at some point in time. Yet, he still managed to trounce the S&P 500 (a broad market index in the U.S. akin to the Straits Times Index (SGX: ^STI) we have here in Singapore) comfortably. Meanwhile, Templeton has a quote that reads: “Diversification should be the corner stone of your investment…
Study great investors like Peter Lynch and Sir John Templeton and you will likely notice how they often try and diversify when they invest.
During his short-but-glorious career managing the U.S.-based Fidelity Magellan fund from 1977 to 1990, Lynch had famously held more than 1000 companies in his portfolio at some point in time. Yet, he still managed to trounce the S&P 500 (a broad market index in the U.S. akin to the Straits Times Index (SGX: ^STI) we have here in Singapore) comfortably.
Meanwhile, Templeton has a quote that reads:
“Diversification should be the corner stone of your investment program. If you have your wealth in one company, unexpected troubles may cause a serious loss; but if you own the stocks of 12 companies in different industries, the one which turns out badly will probably be offset by some other which turns out better than expected.”
To be clear, Lynch and Templeton are bona fide legends in the investing world. During his time with the Magellan fund, Lynch had delivered annual returns of some 29%. As for Templeton, his Templeton Growth Fund had gained 16% per year for nearly 40 years from 1954 to 1992.
You might wonder: If they’re such good investors, why did they not just invest in a small handful of companies they’re most convinced of in order to maximise their return?
Thing is, great investors often diversify because they have enough humility to know that there’s an element of unpredictability in the investing world which necessitates the need to protect themselves from unexpected shocks. To that point, here’s another great quote from Templeton:
“The only investors who shouldn’t diversify are those who are right 100 percent of the time.”
Unfortunately, no one can be right all the time. For overconfident investors who think they have the Midas touch, they might be setting off toward a very dangerous path in their investing journey.
Overconfidence might be one of the most dangerous attributes an investor can have. This character flaw – where we overestimate our own abilities – is actually the driving force behind the demise of Long-Term Capital Management (LTCM) in 1998, one off the largest collapses in the hedge-fund world.
LTCM was founded by many intelligent investors, including economics Nobel Prize winners Myron Scholes and Robert Merton. But, these investors were overconfident in their mathematical investing models for arbitrage activities and piled on the leverage in order to make great returns. But when the Asian Financial Crisis and Russian debt debacle in the late 1990s hit, LTCM failed after losing more than US$4.6 billion in less than 4 months.
Here’s investing maestro Charlie Munger’s account of the LTCM saga:
“Similarly, the hedge fund known as ‘Long-Term Capital Management’ recently collapsed, through overconfidence in its highly leveraged methods, despite I.Q.’s of its principals that must have averaged 160. Smart, hard-working people aren’t exempted from professional disasters from overconfidence. Often, they just go around in the more difficult voyages they choose, relying on their self-appraisals that they have superior talents and methods.”
We all want to believe we are smarter than others. And it certainly feels good when we invest in a company and our investment gets proven right. But, luck may have had a huge role to play in the success of our investments – and that has nothing to do with our intelligence.
We also have to understand that no matter how good we might think we are, there are many things about investing that we are unable to control or even know about (yes – there are unknown unknowns in investing). Thus, to mitigate those risks, we have to make sure we’re diversified. If not, we might pay a steep price for being overconfident.
There're a lot more interesting things about investing to talk about and if you'd like to do it in person, you can come meet David Kuo and the rest of the Fool Singapore team on August 15!
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn’t own shares in any companies mentioned.