From: Chuck Donalies, CFP®
[mailto:firstname.lastname@example.org] On Behalf Of Chuck
Donalies, CFP®Sent: Friday, February 5, 2016 9:00 AMSubject:The Frugal Planner's Weekly Dispatch, Volume 2, Issue 6
Planner's Weekly Dispatch Personal Finance, News, Ideas, and Things I Find
Volume 2, Issue 6 February
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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.
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.
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!
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
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%
Congratulations, your superhero stocks have saved
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.
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.