Lessons 1-5

Lesson 4: Diversification

 

“Don’t put all your eggs in one basket”

-An interpretation of a line in Don Quixote

So we know that given a return we don’t want to take on any more risk unless we have the possibility of more gain. Great! How do we minimize the risk we already have?  As the cliché phrase above hints at one way commonly used to manage risk is the practice of diversification.  Let’s start by defining it.

Key Points

  • Diversification is an essential aspect of any investment strategy
  • Diversification decreases risk of a portfolio by decreasing volatility of the entire portfolio
  • Diversification is useful up to a point, but exhibits diminishing marginal returns

What is Diversification?

Diversification is a method of minimizing risk by investing in a wide variety of securities in a portfolio. A portfolio is simply the total collection of investments a person has. For example say I have invested in some rare art (Mr. Artsay’s of course), land, stocks, and bonds.  My portfolio includes all of these securities or investments.  By investing in all sorts of assets (stocks, bonds, etc.) you reduce the dependence on any one investment type.

An Example

Pic of Rainbow and Pot of Gold
Sadly there are no pots of gold lying around in Rainbowville.

Say I live in the magical town of Rainbowville and have two investment options. I can either buy stock (for now just think of stock as a small piece of a company) in a lemonade stand or a hot chocolate stand.  If I invest all my money in the lemonade stand I will be very happy during the hot summer months when the lemonade business is booming, but not so thrilled during the cold winter season when no one needs a cool drink. On the flipside if I invest all of my money in the hot chocolate stand I will be thrilled during the winter when there is a line for a nice hot drink, but not so happy in the blistering summer months. How do I make the best of this situation? Simple. Instead of investing all my money into one stand I split my investments between the two. This way whether during the summer or the winter my investment is making money.  This is a very simple example but it highlights the main benefits of diversifying.  By diversifying I decreased the volatility of the returns my investments. Put differently, my total return will be more constant by holding both the lemonade and hot chocolate stand instead of holding just one.

So In Real Life This Means?

Well unless you live in Rainbowville (and I will have to research if such a place exists, if not I call dibs) the real world offers a lot more investment opportunities than lemonade and hot chocolate stands.  Stocks, bonds, ETFs, real estate, and munis are just some of the countless options you have as an investor.  So how do you diversify?

The basic idea is to diversify and hold different investments.  Based on this some will go out and buy stocks of all the technology related companies in the market (Apple, Amazon, Intel, IBM) and come back and say “Colby you lied! I diversified and bought all of the technology stocks and now the technology field is doing terrible thanks to XYZ event.” My rebuttal would be as follows: “Ok so the idea of diversification is to make sure that one investment’s performance is not in any way related to the performance of the other investments. Don’t you think that there is an underlying connection between all those stocks? Like the fact they are all technology companies? Like an event like XYZ could hurt all those companies?”

We can extend this proactive logic to the point that our portfolio should include a bit of everything to maximize diversification, but our portfolio will reach a state where diversifying further will not affect it that much. There is math behind this but for now accept the fact that diversification is useful to a point, but needlessly over diversifying can be somewhat of a waste. So now that we know that we should hold some different investments let’s finally discuss those fun things.

Definitions

  1. Diversification: a risk management technique that allocates funds between different investments whose returns are uncorrelated in hopes of minimizing returns achieved
  2. Portfolio: the total collection of investments a person possesses
  3. Diminishing marginal returns: the concept that adding more of some input will produce less and less output

Further Reading

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