Great Savings #46 – Diversify

 

What happens when you carry all your eggs in a single basket? You risk a total loss.

Mr. B needs to diversify.

No doubt you’ve heard the expression, “Don’t put all your eggs in one basket.” There’s a lot of wisdom in that statement. If you carry a big basket holding all your eggs and drop it you’re likely to end up with a huge mess. If you split the eggs up among several baskets dropping one doesn’t affect the other others so the potential loss is considerably less. In much the same way, diversifying your financial assets is a great way to protect yourself from a devastating financial loss. Let’s take a look and see exactly how this plays out.

 

Types Of Diversification

 

Should gold be part of your portfolio?

You can diversify in many ways. Some people include gold in their portfolio.

There are many types of diversification when it comes to money. You might hold different types of assets like stocks, bonds, cash, real estate, gold, commodities, or otherwise. Some assets do better or worse under certain market or economic conditions. Thus, when you select various assets that don’t all go up or down in unison you can often mitigate the risk of a large loss. To understand the importance of limiting loss and especially a large loss see our post: “A Key Secret To Winning As An Investor.”

 

Should you own stocks?

You might own stocks. For example, you could invest in a utility or perhaps a company making wind power equipment.

You might also own different types of assets within an asset class, like a number of different stocks. Let’s consider an example to see why this is important: Say you are interested in owning stocks and recently bought shares of Apple because you love their products. You’ve watched Apple run up profits and dominate the market for several years. Unfortunately, you bought right before Steve Jobs passed away, and now the new Apple products coming out just don’t seem as revolutionary as they once were. Maybe there’s been a slow growth quarter or two on top of everything else. The result is shares of Apple recently “tanked” in the market, and that means your shares went from $600 a piece to $450 and you lost 25% of your original investment. That’s a huge loss.

 

Now, let’s assume that you bought 2 stocks instead of just one. In this case, we’ll say you bought IBM and Apple shares in equal proportions. Assume IBM shares go nowhere and Apple drops like it did above. Instead of losing 25% of your money, you lose 25% of your money on only half your investment.

 

Did you lose money owning Apple?

If your shares of Apple go down will it result in a huge loss? Not if you’re diversified.

Let’s dig deeper: Say you invested $1200 total. The IBM portion remains at $600, but the Apple portion goes to $450. To calculate the percent loss we start by determining the current market value of our total investment (i.e. we add the current value for IBM plus the current value for Apple). That’s $600 plus $450 or $1050. To calculate the loss we subtract the total current value from the total original value or $1200 minus $1050 and end up with $150. This loss as a percent of the total investment is then calculated by dividing it as follows: $150 divided by $1200 equals .125 or 12.5%. In other words, by diversifying you cut your total loss in half.

 

Our example might have turned out much better. IBM might have gone up while Apple went down. That means you might have gained on your overall investment instead of losing on it. Of course, there is a risk that both stocks go down at the same time and that could increase your overall loss. Even so, the more diversified your investments—meaning the more stocks and perhaps bonds or other investments you own—the less likely you are to suffer a big loss and that’s important.

 

 

If you continue to carry out the example above and select 4 stocks, 8 stocks, 16 stocks, etc. you can quickly see how the risk of a big loss is greatly diminished the more stocks you own. Splitting an investment within an asset class—in other words buying more instead of fewer stocks—is a great way to diversify. For this reason, many people buy exchange traded funds (ETF’s) or mutual funds containing a “basket” of stocks rather than a few individual stocks. These funds often hold 30 to 100 stocks or more.

 

To drive home the incredible power of diversification, take a quick look at the chart below. It assumes all the stocks you buy hold a constant value except for Company Z which suffers a total loss. Now, a total loss for a company is rare, but had you invested all your funds in it you would have been wiped out. However, in this example, your loss is limited to 10%. That amounts to an incredible life-saving 90% difference.

 

The power of diversification is it cuts your total risk.

This example shows the power of diversification. If you just owned Company Z shares your loss would be total–100%. However, as Company Z represent 1/15 of your total investment a 100% loss in it is only a 10% loss overall.

 

There’s yet another type diversification risk common in significant relationships. If couples don’t spend time talking about it, they risk inadvertently buying the same investments. This can occur quite easily. Say each buys a “large cap stock fund”. Unless they look at the stocks making up the fund, they could very easily be buying the same stocks without knowing it. The trouble comes when those stocks hit a rough patch in market. Now, their overexposure to the jointly held companies in the funds they own means their combined loss is greater than it might be. For more on this topic, read our post, “Avoiding Joint Financial Disaster.”

 

Would you include art as an investment?

Some investors make art or antiques a part of their investment portfolios. The risk is the market for these items is much smaller than it is for stocks an bonds, which makes determining their value tricky.

So how do you decide which assets or investments within an asset class to own to best diversify your portfolio? Before you decide to invest in anything plan to do some basic research. There is a wealth of information available on the internet. We encourage you to take the time to dig deeply. Many promises are made or implied when it comes to investing so want to approach with a good degree of skepticism. Two articles we wrote that may help get your started include: Diversification: The Safe Money Machine and The Lazy Investor.

 

There's a time value to money.

A critical element of investing is the amount of time you hold onto an asset. Some more risky investments like stocks may offer better returns as long as you can hold onto them long enough to appreciate.

Your tolerance for risk—meaning your tolerance to accept bigger losses—is another critical part of the equation. If you hold only cash, there’s very little chance your money will earn enough interest to beat the rate of inflation. That means you’ll gradually lose purchasing power over time. However, you’ll insulate yourself from the risk associated with market losses as occurs for stocks or bonds. On the other hand, if you hold stocks rather than cash you might gain or lose as the stock price fluctuates, but over time you’d expect the stock to return an average 5-8%. In addition, if you own a dividend paying stock you would receive dividend payments that increase your overall yield. Thus, the risk you assume reflects not just a potential for loss but also a significant potential for gain.

 

Do you include real estate in your portfolio?

Some people consider their home a “real estate” investment, but others would only include real estate investments like undeveloped land, a rental home, multi-family apartments,commercial office space, real estate investment trusts, etc.

The investments you choose as you go to diversify should ultimately correlate to your tolerance for risk in owning a particular investment or a particular class of investments. In other words, some will want to invest in only large cap stocks and others might want only mid-cap stocks. Some will want to hold a good mix of stocks and some won’t hold any stocks whatsoever. Some will want to own real estate and others wouldn’t touch it with a “ten foot pole.” Some might buy gold, etc. For more on risk, read our post “What Kind Of Investing Is Best?”  and for more on dividend paying stocks read “Collecting Rich Dividends”.

 

There are several additional items worth considering as you go to build a successful, well-diversified portfolio. For a list of good basic tips, read our post, “Great Savings 14 – Save On Investing.”

 

This is Great Savings Tip #46 - Diversify. Action Item: Decide on a diversification strategy—that is a mix of the types of investments you plan to hold. For example, maybe you’ve decided you are willing to risk owning stocks and bonds, but not gold or real estate. Now, assign a percent for each asset class. Maybe you decide to own 50% stocks and 50% bonds, or maybe 60% bonds and 40% stocks. Now, look at specific investments you own or plan to buy. For example, say you own or plan to buy a general bond fund and two stock funds. Get a list of the actual stocks from both stock funds and compare them. You can find this information in the fund’s prospectus which is often posted online. If you find both funds hold many of the same stocks, then you may want to consider owning a different fund to meet your diversification goals.

 

Note: We cannot advise or recommend purchasing specific investments. Before investing funds, be sure to investigate and understand the risks involved. How? Search for detailed information online. Read the prospectus that applies to a potential investment. Talk to a certified financial planner. Ask a trusted friend who is familiar with investing. Investigation by itself can’t prevent a loss, but it should help minimize the risks. Finally, never risk any money on an investment that you’ll need in order to cover basic living expenses like food, utilities and rent.

 

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