Fraud, incompetence, unforeseen events: all can cause the investment case for a company to collapse – and the share price with it. No business is immune from the possibility.
To decline to invest in stocks because of this simple fact of life would, of course, be a mistake. Most businesses avoid such dramatics and investing in shares is the best get-rich-slow scheme in existence for the average person.
How do we square the circle? How do we keep the risk of disaster from the occasional implosion under control while we give ourselves exposure to the growth that only stocks can realistically offer?
The answer is obvious, of course: diversification – the holding of enough different stocks to render the odd collapse more or less irrelevant against the long-term growth we can expect from more successful selections.
That answer is perhaps so obvious that some readers may wonder why we feel it to be worth stating at all.
Last week Questor spoke to one reader who had broken this rule and faced, so far only on paper, an appreciable loss of wealth. This column believes share tips can help savers to invest profitably, but only if those tips are used in the right way. Used wrongly, the consequences can be devastating.
This word is not used lightly. Questor recalls a conversation several years ago with a different reader who had invested the bulk of his pension in a company tipped here whose share price had collapsed (management incompetence was the cause on this occasion). As a result the reader’s financial position was dramatically worsened and he was, as you might expect, distraught.
Both readers made the same mistake: they invested a large proportion of their wealth in a single stock. This is the investment equivalent of driving a car after you’ve drunk a bottle of whisky: disaster may not be inevitable, but the chances are not in your favour.
So let’s restate the first rule of buying shares: if you are investing sums large enough that their loss would cause you financial harm, spread the risk by buying a variety of stocks. Do not, in any circumstances, no matter how strong your belief in the company or how thoroughly you have researched it, put the bulk of your wealth in just one.
How many different stocks do you need to hold before your risk is properly balanced against the likely rewards of long-term stock market investment?
Look at it this way: if you have a portfolio of 20 companies and one goes bust, you need just 5pc average growth from the others to make good your loss. Stocks rise by a long-term average of about 8pc annually, so you could expect to recoup the lost money in less than a year.
A 10-stock portfolio would take a little more than a year to recover. Either outcome strikes Questor as bearable, especially if the portfolio goes on to grow at that same average rate for a decade or two.
Would 10 stocks really be enough? There is no hard and fast rule but in Questor’s view it depends on the kinds of stocks you buy. If you only invest in tech start-ups (a risky proposition to start with and not one we would advise), you need a larger number of shares to offset the increased risk of failure of individual businesses.
If all your holdings are long established, stable and profitable companies, 10 may be enough, especially if you have the time to research and monitor 10 stocks but not 20.
Update: U&I
We tipped this regeneration specialist in May 2018 when the shares stood at 234p and quoted one optimistic investor who expected them to reach 275p. Unfortunately they never did – and now they never will, because the company has accepted a takeover bid from Land Securities, the FTSE 100 property giant, at 149p a share.
Although in theory another bidder could emerge, it does not seem likely as the shares are trading within a whisker of that sum. Readers face a loss of 36pc and we can only hold up our hands and admit to our mistake this time.
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Read Questor’s rules of investment before you follow our tips.
