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Rekenthaler Report

There Is Only One Reason to Have Diamond Hands

The best strategy for maintaining conviction is a diversified stock portfolio. The others are merely lottery tickets.

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A Bridge Too Far

If you are old enough to have voted for or against Bill Clinton, you may be unaware of the term diamond hands. (If you can say the same for Jimmy Carter, almost certainly not.) The phrase was coined only recently, in a Reddit discussion board. Per dictionary.com, “Diamond hands is a slang term for an investor who refrains from selling an investment despite downturns or losses.”

That seems sensible. Novice investors are counseled not to be rattled by stock market slumps, but instead to stay the course. The 401(k) system is similarly structured, with participants expected to retain their funds for decades. And the most respected of all investors, Warren Buffett, famously stated that “our favorite holding period is forever.”

The precept of investing with conviction, however, has been stretched well past its breaking point. In practice, the term diamond hands is rarely used to describe investors who hold either diversified equity funds or the type of blue-chip businesses that Buffett buys. Instead, the phrase typically describes those who hold, and keep holding, highly uncertain assets, such the stock of an emerging company, cryptocurrencies, and nonfungible tokens.

Investment Faith

There is nothing regal about such assets. They might eventually become virtual diamonds, being worth far more than their owners paid, but their outcomes cannot determine their statuses. After all, a winning lottery ticket can also be wonderfully lucrative, but steadfastly playing the lottery is neither virtuous nor wise. Nobody ever called holders of lottery tickets diamond hands.

Unlike with the U.S. stock market, speculations do not provide a reasonable expectation of success. For two centuries, corporate America has consistently, if sometimes erratically, grown its earnings. Of course, as David Hume argued, that the sun rose yesterday does not mean that it will rise tomorrow. The pattern may change. Nevertheless, that is overwhelmingly the way that one would bet.

Not so with the shares of an emerging company. Most will languish, some will post moderate gains, and a happy few will flourish. But investors will rarely be able to distinguish between those three groups in advance. Such securities are another form of lottery ticket. Venture capitalists, who know the field better than anybody, realize how the emerging growth stocks should be treated. They buy stakes in dozens of companies, not just one.

Even less certain are the prospects of collectibles that will never generate cash, such as cryptocurrencies and NFTs. As collectibles cannot be valued by formal calculations, their success depends on market psychology. They are worth what somebody else will pay. Holding them is thus a matter of investment faith.

That conviction is misplaced. Not, mind you, that I am predicting collectibles’ downfall. Quite the contrary; last October, I suggested that as speculations go, bitcoin was sounder than most. (So far, I have been laughably wrong.) Rather, I deny that collectibles can be diamond-hand investments. Any alleged “analysis” is guesswork, masquerading as insight.

Mental Accounting

There is a smorgasbord of reasons why so many diamond-hand investors believe they’re winning the game. Among the many psychological tendencies documented by behavioral researchers that might lead to such assurance are:

Overconfidence: Sometimes called “the illusion of validity.” People know less than they think that they do, and their predictions are less accurate than they suppose them to be. (Well, of course, we respond—that perfectly describes our spouses.)

Optimism Bias: People overestimate the probability of a successful outcome. They remember their successes and forget their failures.

Endowment Effect: People often place a higher value on items that they possess than on similar items that they do not. Consequently, even in nontaxable accounts, they tend to retain existing investments that they would not buy today.

Sunk Cost Fallacy: This quirk should be familiar. Once people have invested time and energy into something, they are reluctant to change direction.

Ostrich Effect: A corollary of the sunk cost fallacy is that people disregard news that might force them to re-evaluate their decisions. The ostrich effect is also related to Confirmation Bias, which describes how people cling to their beliefs.

Dunning-Kruger Effect: This error could also be called “the sucker at the table.” The Dunning-Kruger effect asserts that when people are in far over their heads, they sometimes react by thinking that the rest of the world is mistaken, not them.

The Real Thing

In short, although most portfolios that are said to require diamond hands are nothing of the sort, various mental biases nudge their owners into regarding them as relatively sure things. That diamond-hand investors are typically males under the age of 40 is no coincidence. Men suffer more from overconfidence than do women, and the young assume greater risks. Combining the two attributes leads to the group that dominates not only diamond-hand-style investing, but also online gaming and sports gambling.

Don’t take it solely from me. In a well-timed note, Bloomberg’s Matt Levine cites an academic paper bearing the indelicate title of, “Individual differences in susceptibility to financial bullshit.” (I need to start writing better headlines.) The authors conclude: “Consumers particularly vulnerable to financial bullshit are likely to be young, male, have a higher income, and to be overconfident with regards to their own financial knowledge.” In other words, those with diamond hands may have been sold coal, without realizing the difference.

The one portfolio worthy of diamond hands? That I have already disclosed. It is a diversified equity portfolio. It may come variously—through directly held securities, or actively managed funds, or indexes. The method is immaterial if the costs are low. What matters is shifting the odds. A diversified equity portfolio does that, by placing history on investors’ side. It supplies the reason for the investment faith.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.