Disclaimer: I am not a certified financial advisor, and this article does not constitute financial advice. This article reflects my personal views as a student of investing.
At first glance, investing in the stock market might seem fun and simple: find the companies you like or admire, buy their stocks, and watch your investments grow. But unlike choosing how to dress yourself, investing based on brand names or personal tastes is not the best way to build long-term wealth in the stock market.
One of the most important and fundamental ideas in investing is understanding price versus value. The stock of a great and popular company can still be a poor investment if that stock is overpriced. This can happen when many people buy the stock of a company simply because they like it, regardless of how earnings have been trending in comparison to the stock price.
When too many people chase a stock, demand pushes its price beyond what the company is reasonably worth. That means new investors would be paying a premium, which lowers their potential returns. Instead, investors should focus on buying stocks whose price is lower than the actual value of the company today.
Even if you have calculated the "cheapest" stock to buy and invested in it, there are no guarantees in life—or, as they say in investing, "there's no free lunch." Investing is inherently risky, and that risk can come from many sources: changes in company earnings, management, or competitive industry dynamics. This is where diversification comes into play. Instead of betting your entire savings on one individual stock, the best way to manage risk is investing in many stocks at one time. This way, if something goes unexpectedly wrong for one company, it does not have an overwhelming negative impact on your portfolio.
There are many ways to achieve diversified investing. You could in theory evaluate all the stocks in the investible universe and pick your 50-100 "cheapest" stocks. Thankfully, there are prepackaged portfolios called "indexes" that do much of this work for you—with additional benefits we'll discuss in future articles.
For now, just know that you are taking a very important step in securing your long-term financial future by investing wisely—not by chasing fads, but by understanding price versus value and diversification. These ideas connect to deeper concepts known as the Efficient Frontier and Efficient Market Hypothesis, which we'll explore further in upcoming issues.