What Everybody Needs to Know About Investing

Investing can be downright puzzling. Or not, if you believe Gregory Treverton.

In a 2007 article for Smithsonian magazine, Treverton highlighted the difference between a puzzle and a mystery:

There's a reason millions of people try to solve crossword puzzles each day. Amid the well-ordered combat between a puzzler's mind and the blank boxes waiting to be filled, there is satisfaction along with frustration. Even when you can't find the right answer, you know it exists. Puzzles can be solved; they have answers.

But a mystery offers no such comfort. It poses a question that has no definitive answer because the answer is contingent; it depends on a future interaction of many factors, known and unknown. A mystery cannot be answered; it can only be framed, by identifying the critical factors and applying some sense of how they have interacted in the past and might interact in the future. A mystery is an attempt to define ambiguities.

Whether you're a conservative investor searching for dividends, a value hound looking for bargain-basement valuations, or a growth fan looking for the next big thing, the value of your investment always boils down to what will happen in the future. Or, as Treverton puts it, "a future interaction of many factors, known and unknown."

In short, we investors may have more in common with Sherlock Holmes than we thought.

The mystery mind-set
The distinction between puzzle and mystery may seem trivial, but that's far from the truth.

If you invest as if you're working on a puzzle, then you believe that finding certain pieces of information will give you the answer on the particular investment that you're evaluating. If so, you're either tirelessly spending your days (and nights) searching for that magical solution, or you're overconfident in the information that is available.

On the other hand, looking at investing as a mystery forces us to deal with two very important realities:

  1. You can never have 100% certainty on any investment.
  2. Thus, diversification is key.

Let's look closer at the hows and whys of these realities.

You don't know jack
In search of certainty, we could crack open Microsoft's (Nasdaq: MSFT  ) most recent 10-K and read it front to back. We could then pour ourselves a monster-sized cup of coffee, and read through every other filing Microsoft has issued in the past year. Heck, we can read every filing the company has ever issued. Top that off by visiting the headquarters, buying and using every Microsoft product, interviewing CEO Steve Ballmer personally, and doing extensive checks on Microsoft customers.

Even after all that, however, we still won't be able to say for sure what Microsoft's stock should be worth. The value of any stock will always be based on what the company is expected to produce in the future. Unless you have the gift of precognition, you'll never have all of the information you need for an exact valuation.

If you can't divine, diversify
Warren Buffett has famously quipped that diversification is "protection against ignorance," and I couldn't agree more. As in the example above, we'll always be ignorant of future events, so it makes sense to protect ourselves through diversifying.

Of course, diversification doesn't simply mean buying multiple stocks. Augmenting a purchase of Microsoft with Oracle (Nasdaq: ORCL  ) and SAP doesn't really help you much if you're ultimately wrong about the software sector in general. Diversification means investing in a mix of stocks across categories like industry, size, and geography.

A diversified "starter kit" might look something like this:

Company

Market Cap

Industry

Geographies Served

Microsoft

$249 billion

Software

Global

America Movil (NYSE: AMX  )

$75 billion

Telecom

Mexico

Markel (NYSE: MKL  )

$3 billion

Insurance

U.S.

Total (NYSE: TOT  )

$126 billion

Energy

Europe

Tongjitang Chinese Medicines

$117 million

Health care

China

Source: Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

While these aren't meant to be formal recommendations, the table illustrates a truly mixed portfolio. By diversifying, you ensure that even if you're wrong about the prospects for the software industry, you can be right on the money when it comes to China, and still end up with handsome gains at year's end.

Eggs, baskets, and the right amount of diversification
Though it's a time-honored maxim, "don't put all of your eggs in one basket" doesn't help us figure out how many eggs and baskets we should have.

On this topic, I happen to agree with my fellow Fools Julie Clarenbach and Tom Gardner. Last fall, Julie wrote:

Tom Gardner, co-founder of The Motley Fool, believes in the "sweet spot where each position is large enough to make a difference if the stock takes off, but small enough that a 25% to 50% drop would not cause significant damage." ... I'd argue that a portfolio of less than 10 stocks brings too much risk, while a portfolio of more than 30 stocks will likely dilute the reward. The sweet spot, then, is somewhere in between.

While the optimal number of stocks might differ from person to person, the key thing to remember is that while you want variety in your portfolio, you still have to figure out the mystery of each stock. If you have 100 stocks in your portfolio, it'll be pretty difficult to gather and analyze enough information on each to make an informed investment. For most investors, the 10 to 30 range is likely manageable, while still giving you diversification protection.

Of course, there's no reason why you have to go sleuthing and diversifying on your own. The investing team at our Motley Fool Stock Advisor newsletter has an open-ended mandate to find the absolute best stocks. This has allowed the team to recommend stocks ranging from well-known large-cap Apple (Nasdaq: AAPL  ) to the much smaller and lesser-known conglomerate Leucadia National (NYSE: LUK  ) .

If you'd like to check out Stock Advisor's recommendation list, to see whether it can broaden your investing horizons, take a free 30-day trial of the newsletter.

Whether or not you decide to check out Stock Advisor, I sincerely hope that you stop puzzling over stocks, and see through to their truly mysterious nature.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. Markel and Microsoft are Motley Fool Inside Value recommendations. Apple and Leucadia National are Motley Fool Stock Advisor selections. America Movil is a Motley Fool Global Gains pick. Total is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Markel and Oracle. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 11, 2010, at 12:59 AM, TMFKopp wrote:

    @truthisntstupid

    "Usually valuation is something I'm not going to worry about for companies I intend never to sell, as long as they have a decent yield now."

    I'd argue that valuation and yield aren't mutually exclusive. Generally speaking, a company carrying a decent yield is more likely to be fairly valued than a company that has a tiny yield. I hit on that a little bit in this article: http://www.fool.com/investing/dividends-income/2010/02/01/ma...

    Matt

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