The world of investing is attractive because of its potential to grow your wealth more rapidly than traditional savings accounts can. As part of evaluating the market, individuals are often enticed by investments currently exhibiting unusually strong performance. It’s tempting to buy into stocks or a market sector that is hot on the assumption that strong investment returns will sustain to capture a nice profit. However, it’s important to remember that extreme returns are seldom maintained and can also quickly result in losses.
The Risk of Buying into Strong Performance
Sometimes investments that are doing well continue to remain profitable. However, there’s also a risk that most of the growth has already occurred by the time the average investor hears about a hot trend. This means they might buy after the investment peaks and never realize the profits they’re seeking.
It’s also important to remember that trends frequently reverse. It is not uncommon for companies or sectors of the economy to experience turndowns. The energy sector is a prime example as it’s highly dependent upon the strength of the economy, oil demand, and variations in output.
What Drives High Individual Stock Returns
High-flying stock prices generally result from strong current demand for products or services, or the anticipation of strong future demand. If current demand is high, investment returns can be based upon strong investment fundamentals. However, if stock price acceleration is based upon future expected demand, stock valuations are more speculative.
Here are some examples:
The release of the iPhone resulted in tremendous demand for smartphones and sales exponentially increased. Apple’s stock price soared and the price runup was based upon true company performance and strong revenue numbers. This is an example of when stock price growth is based upon company fundamentals, giving greater support of continued company strength. Decades later, Apple has continued to post very respectable returns. However, it should be noted that demand can wane in any given company or market sector for a variety of reasons.
Conversely, two other examples include the internet boom of the late 1990s and the more recent cryptocurrency craze. Both were based upon assumptions of future growth with little evidence. The internet boom largely assumed that internet companies would derive substantial revenues from advertising. Similarly, the cryptocurrency run assumed greater utilization of cryptocurrency exchanges. In each instance, stock prices were astronomically elevated relative to actual earnings or achievements. Both sectors experienced significant crashes that resulted in ultimate investment losses for many investors.
When Diversified Funds Can Also Experience Greater Fluctuations
It’s important to note that even diversified investments (where you own more than one stock) can experience temporary exuberant returns. This often occurs when investments are concentrated in terms of the number of holdings or in one investment sector.
Extreme price movements among diversified investments often result from:
- Concentrated holdings, such as a mutual fund with less than 100 stocks.
- Investment offerings that limit holdings in a single market sector, such as technology or energy.
- Investments that own smaller niche companies, which have higher risk and may be unprofitable.
- Funds or strategies with a low investment or asset base, constraining liquidity.
Can You Withstand High Risk?
Investors should consider what they’re willing to lose before investing. All investments hold inherent risk, but individual stocks and concentrated positions have higher inherent risk.
If finding the next big investment is attractive to you, consider the pros and cons and how much risk you can take without derailing your long-term goals. Everyone enjoys the profits that an investment can render. However, not everyone can withstand losses when they occur.
If you’re inclined to invest any significant amount of your assets in one stock or in a concentrated manner, such investments should be a small percent of your total investment base or they might be ideal for “fun money.” Fun money represents assets that you can put at higher risk without impacting your financial security. This is especially true for someone relying on their investments for retirement income.
Well-Proven Investment Approaches
A general investment principle is to buy when investments are low and to sell when investments are high. This is achieved by frequently rebalancing your portfolio to take profits and reallocate dollars to areas of the market that are currently out of favor. History has proven that no one sector of the market dominates forever. Market performance rotates. In fact, there are a plethora of instances where the hot investment today becomes the laggard of tomorrow.
Another well-studied investment approach is diversification, which often helps to reduce risk and enhance long-term returns. A diversified portfolio consists of a larger number of investments across multiple sectors of the markets such as stocks and bonds, international and domestic holdings, and large cap stocks coupled with mid- and small-cap stocks.
SageVest Wealth Management helps clients to develop portfolios designed to meet their performance objectives while mitigating risk potential. We follow a disciplined and diversified investment approach that is customized based upon your income needs, growth requirements and risk appetite. Our goal is to grow your wealth while managing risk. Please contact us to learn more about our coordinated investment and financial planning services.