If you’re like me, you insure your car, your house, and your life.
The reason I insure my house is because if it burns to the ground my insurance company will provide the necessary funds to rebuild it. The reason I insure my car is if I crash into a Ferrari LaFerrari, valued at $1.6 Million, I won’t have to sell my house to pay for it, and the reason I insure my life, should be pretty obvious.
So why is it that stock market investors, particularly those that picking individual stocks, don’t take out an insurance policy on their investment?
Huh! I’m pretty sure you can’t insure your shares against losses!
I’m not talking about an actual insurance policy to protect you from loss, I’m talking about diversifying your portfolio. To better understand this concept, lets look at how insurance companies make money.
Simply put, insurance companies provide policy holders with a way to manage risk.
They do this by collecting (pooling) all of the premiums from their policy holders. Then, they payout part of the pool to those policy holders that experience loss in the case of theft, damage, death or whatever the policy covers. Then there’s a whole bunch of over stuff called reinsurance and underwriting, but we won’t get into that here.
Now, lets take a hypothetical example. Lets say our insurance company, CrazyInsurance, have decided that instead of pooling the funds and paying out premiums they will insure just one policyholder, me. That is, I have a house valued at $200,000, and my premiums are $400 per year.
Lets say I’ve paid my premiums for 3 years totalling $1,200 and my house burns to the ground. CrazyInsurance now has to find $198,800 ($200,000 minus $1,200 already paid), to pay for my loss.
Well that’s exactly what share investors are doing when they pick individual stocks!
Lets say you have $10,000 to invest in shares and you pick one stock.
If your pick tanks by 50%, you’re down $5,000.
But what if instead of putting $10,000 into one pick you bought 10 shares. That is, you invested $1,000 equally into 10 picks. That’s called equally weighting your portfolio. You have now spread the risk across ten picks instead of one. Each pick represents 10% of your portfolio.
Now, lets say one of your pick’s tanks by 50%, you’re effectively down by 50% of one pick, or just 5% of your entire portfolio.
Take it one step further, like we do here at The Acquirer’s Multiple (TAM), and invest your $10,000 into 20-30 picks and you further minimise your risk. Now, based on 20 stocks, each pick represents just 5% of your portfolio, and if one pick tanks by 50%, that means your entire portfolio is down just 2.5%.
Hence the reason why Ben Graham bought a broadly diversified basket of bargain shares (25 to 30), reasoning that while some might go bust, on average they couldn’t all possibly be worth as little as they were [under]valued at.
While there’s lots of research on how many stocks you should hold in your portfolio, here at TAM, we recommend 20-30 picks in an equally weighted portfolio.
Now here’s two extreme examples using my own TAM portfolio (below).
I bought Perion Network, using the screens here, for $2.31 on 22/2/2016 and its subsequently fallen to $1.12, down 51%. Conversely, I bought Transocean Partners at $7.82 on the same day and its risen 58% to $12.40. Am I worried about the 51% drop by Perion? NO! Am I excited about the 58% gain by Transocean partners? NO!
Cos, I’m working towards my 20-30 stock equally weighted Insurance Policy (diversified portfolio) that lets me sleep well at night!
For more articles like this, check out our recent articles here.
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