Why successful investors avoid gambling
One of the most famous poker games ever recorded took place at the 2008 World Series of Poker, where Motoyuki Mabuchi, completely confident in the winning prospects of his rare four aces, went all-in, betting all his remaining chips against opponent Justin Phillips. Then, playing one of the most statistically unlikely hands in history, Phillips revealed a royal flush, sending Mabuchi packing with nothing. To put just how highly improbable this outcome was into perspective, the odds of four aces facing-off against a royal flush are about one in 165 million. You’d need to play poker for about 18,000 years – uninterrupted – to land these odds.
For investors, this example demonstrates that no matter how sure or confident you may be, never go all-in on a single share or company. There is always the risk or chance of some crazy outlier appearing, and financial markets are simply no place for gambling. The hope of achieving outsized returns by investing everything in a stock that seems as though it could be the next Amazon, Alibaba or Naspers is highly seductive, but the reality is that for each of these success stories, there are many other companies that have fallen along the way.
An investment in a single share raises the risk of suffering extremely large drawdowns in times of uncertainty, as opposed to if you “hedged your bets” across a range of investments. In other words, by avoiding placing all your eggs in one basket and by diversifying your investments across different industries, sectors, regions and even asset classes, you can mitigate your investment risk. As the chart below shows, even choosing the top performing asset class in any given year is a tall order for investors.
In my own experience, another lesson on resisting the urge to gamble with a single asset or even asset class arose slightly closer to home when a close relative received his severance package. Without being offered access to a financial adviser, and feeling reluctant to seek one out himself, he was tempted into investing all his money in the forex market in the hope of making quick returns on his capital. Needless to say, the imagined “easy win” didn’t materialise, and he lost a substantial amount of this retirement capital. Despite being past the age of retirement, he was compelled to seek re-employment to survive.
And as a final example, the COVID-19-driven rollercoaster ride of the past few months has re-emphasised the importance of diversification for protecting portfolios against economic risk, market risk, industry risk and business risk. For instance, since the pandemic began and economies went into lockdown, travel, retail and shipping companies have experienced extremely sharp declines, while others offering digital streaming and video conferencing have fared much better – events that were impossible to predict. A diversified investment will have had exposure to these winners and gainers, notwithstanding the extremely stressed environment.
South Africa’s own equity market experienced deep declines over the first quarter of 2020, in line with the global sell-off in riskier assets, as the benchmark FTSE/JSE All Share Index (ALSI) – which represents a diverse basket of shares – fell as much as 21.4%. However, it is worth noting that as many as 27 companies fell even more than the index, including former market darlings such as Capitec, The Foschini Group (TFG) and MTN.
Capitec, for instance, was trading above R1,400 a share at the end of 2019, but given that it had been trading at elevated multiples, led the decline in banking shares seen in the first three months of 2020 by falling nearly 40%. TFG, shedding 54.7%, then led losses in the clothing retail sector, which has been particularly hard-hit by the national lockdown, while MTN declined 41.3% on the back of falling oil prices (which negatively impacted its biggest market in Nigeria), as well as the announcement that CEO Rob Shuter would be stepping down at the end of his contract in March 2021.
The three key risks of investing in a single share
To help investors understand the importance of diversification for successful investing, and guard against the temptation of investing in a single company (no matter its potential), here is a brief overview of the three key risks of investing in a single share, namely industry, management and company-specific risk:
- Industry risk:
If the company you choose operates in an industry facing a challenging or deteriorating macroeconomic environment, the share price is likely to be negatively impacted regardless of how well the company may be run. Consider, for instance, the aviation industry, which has recently been hard-hit by lockdowns and travel bans, and is likely to come under pressure for some time. And while oil prices have recently fallen to record lows, if oil prices were to surge again, for example, airlines would also struggle to make any profits owing to increased costs.
- Management risk:
Management teams are ultimately human beings who can make mistakes, and while the management team of a company may have a great track record, this is not a guarantee of wise decision-making and performance into the future. Referring to the example of an airline company, its management may, for instance, make the decision to lock-in the price of oil at a level they believe to be attractive. However, if oil prices were to fall a few months later, the company would inadvertently end up paying far more for the oil compared to its competitors.
- Company-specific risk:
The third primary risk of investing your entire portfolio in a single share is company-specific risk, or the threat that you may lose everything owing to unique challenges and issues facing the company itself. A case in point is Steinhoff’s dramatic fall from grace following the discovery of fraud by its management. Another recent example is Sasol, whose share price has been deeply impacted by the steep decline in the oil price, operational challenges and balance sheet issues.
Diversified investment options
When it comes to investing, putting all your money on a single share is akin to gambling – and shares few parallels with the discipline of investing. A better option than gambling on a single share is to invest in a diversified portfolio of shares such as a unit trust, which is managed by financial professionals who will perform the necessary stock analysis and diversification on your behalf. You could further consider investing in a multi-asset portfolio, which invests across a range of asset classes including shares, property, bonds and cash.
Alternatively, you could consider investing in low-cost exchange-traded funds (ETFs), which track various market indices such as the JSE ALSI. EasyEquities, for example, offers access to professionally-managed ETF bundles, which blend different ETFs and exchange-traded notes (ETNs) to ensure the appropriate exposure to different asset classes, industries and regions to suit the needs of different types of investors.
However, if you are feeling at all uncertain or confused, it would be wise to reach out to a financial expert who is equipped to advise you on the types of investments best suited to your risk profile and investment goals.