February 23, 2021

The Biggest Risk a New Investor Can Make

The COVID-19 pandemic has produced countless knock-on effects — with one of them being millions of Americans discovering the stock market for the very first time.

Whether they were bored at home during lock-downs, missed betting on sports games that had been canceled, or had extra money from their stimulus check to put to work, retail investing has boomed over the past year.

This is a good thing, as the stock market has consistently generated wealth for those that stayed invested for the long-term, and the earlier you start investing, the better off you are.

But there's no manual on how to invest when you open up a Robinhood account, and the US school system has failed miserably at teaching financial literacy to its students.

This is a recipe for disaster, especially when social media videos from influencers that look like your peers amplify speculative investment behavior without spelling out the real-world risks.

All of a sudden, it may feel like everyone is getting rich but yourself, and in order to join in on the fun and not be left behind, you may feel the need to pile into highly volatile securities like bitcoin, Tesla, or GameStop (whatever the fad of the week is).

While your 'YOLO' trade may work out at first, it rarely ends well.

And that downfall is always a real danger for new investors because of the biggest risk they take: concentration.

"Diversification may preserve wealth, but concentration builds wealth." - Warren Buffett

Buffett is right, but concentration to him does not mean putting your entire portfolio into a handful of high-risk investments that are not profitable and are likely overvalued. Instead, concentration to Buffett meant investing in at least a dozen profitable companies that had staying power and reasonable valuations.

There's nothing wrong with owning cryptocurrencies like bitcoin, or high-flying stocks like Tesla, or even high-risk stocks that are trying to stage a turnaround, like GameStop. It only becomes a problem when these speculative investments represent a large portion of your overall portfolio.

As a general rule of thumb, don't let your highest conviction investment make up more than 5% - 10% of your portfolio (wealth) at any given time.

And the most dangerous knock-on effect to concentration risk, especially for new investors, is if the bet doesn't end well, they tend to become disillusioned with the market and abandon it to their long-term detriment.

Keep your concentration risk in-check by investing in a diversified portfolio.

And if you've suffered sizable losses from the recent high-flyers mentioned above, don't be discouraged, it happens to everyone at some point in their investing journey. The key is to learn from the mistake and keep moving forward.

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