Friday, February 05, 2016

The Frugal Planner's Weekly Dispatch, Volume 2, Issue 6 (from Bloomingdale resident Chuck Donalies!)

From: Chuck Donalies, CFP® [] On Behalf Of Chuck Donalies, CFP® Sent: Friday, February 5, 2016 9:00 AM Subject: The Frugal Planner's Weekly Dispatch, Volume 2, Issue 6

The Frugal Planner's Weekly Dispatch
Personal Finance, News, Ideas, and Things I Find Interesting

Volume 2, Issue 6
February 5, 2016

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Avengers Assemble! Captain America, Tony Stark AKA Iron Man, Thor, Hulk, and Black Widow suit up for Halloween 2014.

Also, my youngest daughter is the Best. Hulk. Ever.

POW! ZAP! Diversification!

Not long ago I re-watched Marvel's The Avengers and its sequel, the inferior but still fun Avengers: Age of Ultron. While watching these comic book flicks, I realized the group efforts of the Avengers provide an excellent example of how the concept of diversification works for investments. Stay with me on this.

What is Diversification?
The short answer is that diversification means not putting all of your eggs in one basket. Iron Man is great. Seriously, who wouldn't want Tony Stark's brains, money, and sweet armor? However, when the fate of the world is at stake, as it always is, the odds of saving the day are vastly improved when Iron Man is assisted by Captain America, Thor, Hulk, Black Widow, and Hawkeye. If Iron Man gets knocked down another member of the team can step up and get the job done.

Seriously? How Does This Relate to the Real World??
Let's use Apple as an example of how diversification works in the world of personal finance. Apple is a highly profitable tech company. However, owning a portfolio comprised only of Apple stock is not a good long-term strategy. Let's say Apple's stock falls 20% because consumers stop buying iPhones. You won't be a happy camper if Apple is your only investment!

The Solution
You need to create your own team of superheroes! Unfortunately, the team you'll create won't feature a giant green rage monster or a Norse god wielding a magic hammer. Instead, your team will be comprised of companies in different categories, such as Wells Fargo (financial services), Exxon Mobile (oil & gas), Pfizer (pharmaceutical), and Proctor & Gamble (consumer products). Why companies in different categories? Because it's impossible to predict which categories will be best from year to year. The following chart shows returns for different investment categories from 2003 - 2015.

Investment categories with the greatest returns vary from year-to-year.

Superhero Portfolio Assemble!
Okay, we've established why having one superhero (stock) isn't ideal. The following chart shows a hypothetical portfolio comprised of five superheroes (stocks). Please note the stocks referenced here provide a highly simplified illustration of how diversification works.
Spoiler: Instead of a 20% loss, you have a 3% gain.

Congratulations, your superhero stocks have saved the day!
Instead of a 20% loss, you have a 3% gain!!

For the average investor, owning a portfolio of individual stocks, such as the one in the example above, isn't practical. Fortunately, mutual funds and exchange-traded funds (ETFs) provide investors with an efficient, cost-effective means of holding large baskets of stocks and bonds.

Key Takeaways
Owning one stock is great, but it's risky and could lead to losses. However, owning multiple stocks in different categories typically reduces risk and leads to better long-term returns.

In addition, I've just proven that watching comic book movies is not a waste of time.

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