Remember the Tesla bull run? The one where the stock tripled in just a month or two? Where everyone declared that Tesla was finally getting its break and was ready to take over the world? Well, we’re already back to December 2019 price levels.
If you bought Tesla stock one month ago on February 19, you would be facing a near 60% loss on your money if you had held until March 18. Meanwhile, the S&P 500 has seen a near 30% drop during that same period. If you bought Tesla stock a month ago, your pick has done twice as poorly than if you would have just bought a broader stock index.
The Risk of Stock Picking
Tesla’s recent stock swing shows the difficulty and uncertainty of stock picking. A stock can be subject to incredibly violent price swings for seemingly no reason whatsoever. Perhaps even worse, a random market event, like a pandemic, can drastically increase investor uncertainty and threaten a company’s very existence.
While Tesla is no stranger to big stock price swings, and they probably will pull through as a company in the long run, many peoples’ stock portfolios have been stung, to say the least. A large number of first-time investors bought into Tesla during its historic rise. They now are facing the pain of a company stock crash in the midst of a larger market crash. The Tesla debacle also shows the importance of having a well-diversified portfolio.
Market Risk vs. Specific Risk
There are two types of risk when investing: specific risk and market risk. Specific risk is the risk that a particular stock or industry will do poorly. Market risk is the risk that the whole market will do poorly.
Market risk is practically unavoidable. But specific risk can be avoided by diversifying your portfolio. Think of it this way, the more different companies you have in your portfolio, the less exposed you are to one company’s failures since we would expect not every company to have the same specific risk.
As an example, mighty Amazon has done better than Tesla during the same 1-month time period, facing about a 16% loss rather than Tesla’s 60% drop. Amazon is exposed to different risk than Tesla is. Tesla as a company has a lot more uncertainty and is in an entirely different industry than Amazon, which focuses on logistics and distribution rather than manufacturing electric cars. Having different types of risks in your portfolio will prevent any one of those risks from destroying your whole portfolio.
If you have a large number of different types of stocks in different industries, no one company’s risk will upend your portfolio, assuming it is well balanced. This is where things like index funds come in. Index funds allow you to invest in hundreds, if not thousands, of different companies all within one fund. For example, the Vanguard Total Stock Market ETF holds over 3,500 stocks to give you incredible diversification with very little effort. You just buy shares of the fund like any other stock. But that one share holds micro shares of thousands of other companies. Any single company’s failure can be made up by thousands of others.
But you still are always exposed to market risk, like the pandemic and potential recession we are facing today. Even with the thousands of stocks making up the Vanguard Total Stock Market Fund, it is still down around 30% over the last month. We can confidently say that market risk has caused that 30% dip, since specific risk is practically eradicated with such a diverse fund.
What Do Different Levels of Risk Mean?
What does this mean for you, the investor? As you probably know, higher risk comes with higher expected reward. If you are taking on lots of specific risk, we would expect you to have a higher ceiling in what you can make on that investment. But your downside is much lower, too. Conversely, if you are taking less risk by eliminating specific risk through diversification, we would expect less return as well over the long run. And that expected return without the specific risk is the 7% to 8% per year over the long-run that you have probably heard about before. That is, the stock market as a whole generally returns about that much on average each year.
The likelihood of you beating that 7% to 8% average with a well-diversified portfolio is very slim. But you will have far more consistency in reaching that average than you will by picking stocks. Even if you hit a home run on a stock, the recent Tesla stock bubble shows how delicate those situations can be.
Not to mention, you still have to weigh whether to hold the stock or to sell it and take any gains. Or maybe you want to sell to cut losses only to then see it rise aggressively the next week. Whereas with index funds, you can far more easily buy, hold, and then take in 7% to 8% on average over many years, even if it swings in the short-term. Not every company will last for all of those years. But unless you believe the entire stock market will collapse for good, then your best bet is probably just taking the index for the long run.
Conclusion
In short, diversifying your portfolio is a fundamentally strong and consistent way to avoid unusually massive losses like those from portfolios loaded with a huge ratio of Tesla stock bought a month ago. You eliminate specific risk and only face market risk. This will likely bring you far more consistent returns over the long run.
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