To invest is to purchase rights in an asset with the goal of achieving future benefit and growing wealth over time. In the context of the stock market, investing means buying into great companies under favorable terms so you can share in their long-term success. Doing this well requires understanding the business, its value, and the price you're paying.
Diversification is one of the most misunderstood concepts in investing. It's often thought to mean spreading your investment dollars across the entire investment universe—different asset classes, industries, and geographic regions—to reduce overall risk and volatility by minimizing the impact of any single investment's performance.
To accomplish this, many investors rely on mutual funds or multiple portfolio managers, assuming that more equals better. But this can easily lead to over-diversification, where your investments are so broadly spread that your returns become diluted without significantly reducing risk. The result is often lower overall performance.
The key to effective diversification lies in understanding the correlation between investments. Correlation is a statistical measure of how two investment prices move in relation to one another.
For example, imagine purchasing two large-cap equity mutual funds. Each fund may hold hundreds of U.S. companies. But you don't directly own those companies—you own a proportional share of each fund's average performance, net of fees. In reality, you hold just two investments, and they likely derive their performance in similar ways. Because both funds are invested in large U.S. companies, they tend to react to market events in the same way. These two investments are highly correlated, meaning they're likely to rise and fall together.
Price dictates what kind of deal you get. We hate inflation because it drives prices up. We dislike markups, middlemen and excessive profit margins. What we want is low cost, and quality at an affordable price.
Now imagine walking into the grocery store and feeling excited that your favorite cut of meat is up 20 percent this year. That would be absurd. Yet this is how many people approach investing. If the price is up, they assume it must be good. If it is down, they think it must be bad.
The stock market is simply a store where you go to buy things. Sometimes prices are high. Sometimes they are low. And sometimes, there are excellent deals.
Value is the estimated monetary worth of something. When you apply for a mortgage, banks don’t require an appraisal because they care whether you're getting a good deal. You can buy a house for any price you and the seller agree to. Regardless of what you pay, the bank wants to know what the house is worth so they can determine whether they’ll be able to recover the money if you stop making payments.
For the value to change, something material and specific to the asset being valued must occur.
A blind spot is an area where a person’s view is obstructed. In investing, this often shows up in the irony that many who give advice on how to grow a business have never actually built or run one themselves. Culture, leadership, and strategy are some of the most important factors when considering a company’s future.
It doesn’t matter how the numbers look or what you think the future of the market holds if the business is unable to execute effectively. Conversely, a company may appear to be struggling just before new leadership steps in, implements a new strategy, and changes the culture—staging a legendary comeback.
Understanding these factors is crucial when evaluating where a company’s value is likely headed.
