Explain Diversification Like I’m Five Years Old

How to strengthen your portfolio through diversification

Cliche aside, when it comes to choosing your investments, there really are no wiser words than:

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

No matter how hard you analyze and no matter how hard you research, at the end of the day…investments are a calculated gamble. The only way to mitigate (lower) your risk is through strong portfolio diversification.

But First – What is Portfolio Diversification?

Portfolio diversification means introducing variety and spreading out them investments.

Take a look at Suzie.

Suzy diversification

Suzie’s a freshman in college and looking to fill up her course load. Suzie knows – without a doubt – that she wants to be an accountant. Because of that, she will only take courses like math, statistics and accounting. She’s determined to only take courses that will benefit her desire to become an accountant.

This course selection strategy can be pretty risky. Imagine two years down the road, Suzie has a change of heart…she wants to be an artist. She was born to be an artist. Those two years of accounting classes have been kind of wasted.

What Suzie should have done was diversify her course load – she should have taken a few accounting classes, a few art classes and maybe even a few science classes. Sure, it may have extended the length of her education, but in the end it would present more opportunities long-term.

The same philosophy applies to investing. Even if you believe that a certain stock will succeed, it’s not recommended to put all your cash in it. No matter how certain you are, you cannot predict the future. Just as Suzie would have been prudent to take a few different courses in case she changes her career path, you should invest in a few different companies to protect against losses.

Still not clear? Check out this video on portfolio diversification strategies:

Murphy’s Law 

Murphy’s Law states that what could go wrong will go wrong. In the world of investing, this advice should be taken as gospel. Every single company that you own has the opportunity to fail. Do yourself the favor and lower that risk by investing in a handful of companies. Even if one of your companies fails, the other ones will balance out your overall losses. It’ll be a less painful process.

4 Types of Portfolio Diversification

Now that you know about diversification, let’s look at how to diversify:

1. Buy other stocks from the same industry

You can start by buying multiple stocks in the same industry. This works well if you think a particular industry is strong, but reduces the risk that one company might fail. This often means buying companies that are competitors. 

How to do it: Buy equal amount of 2 stocks from the same industry.

Example: Buy 10 shares of Google and 10 shares of Apple from the technology industry.

2. Buy stocks from other industries

Be sure to invest in stocks from a variety of different industries. What if you chose companies in the natural gas industry, but the demand for natural gas dropped because solar energy became way cheaper? Your stock and all its competitors’ stocks would drop together.

How to do it: Buy shares in 2 new companies from different industries.

Example: Now that you own Google and Apple, buy Exxon from the natural gas industry and First Solar Energy from the solar energy industry.

3. Buy stocks with different characteristics

Stocks are characterized differently not only by what industry they belong to, but also by factors such as how big they are or how likely are they to grow. Historically, smaller companies have done better than larger companies, simply because there is more room for them to grow. However, larger companies are more stable and have proven their worth, and hence can be safer investments. 

How to do it: Head over to the stock screener. You can adjust the market cap range to find companies with smaller or larger market caps.

Example: Apple, Google, Exxon and First Solar are all really big companies. Add a smaller company like SodaStream International to your portfolio. 

Similarly, there are growth stocks and value stocks. Growth stocks are companies that have  amazing new ideas that cause them to boom to success, whereas value stocks are more stable dividend paying stocks that will grow more modestly.

How to do it: You can find out if a company issues dividends by looking at the div yield section of the quote page

Example: Buy a company like Johnson & Johnson that issues regularly high dividends 

4. Think outside the stocks

You can choose to buy different types of investments to make up for the risk that the whole stock market poses. For example, in a recession, almost all stocks lose value – no matter that they are completely different. This is because people lose confidence in the stock market as a whole, and put their money in things considered safer such as bonds. You can diversify your portfolio more by adding a few bonds to them.

You can’t take out all the risk

At the end of the day, you can only protect yourself from so many things. Some risks are out of our control. This is the same in the stock market. We cannot predict things like a recession or the planet exploding or an asteroid crashing, or people refusing to work. These things are called market risk and cannot be diversified away.

Check out the Wall Street Survivor definitive course on Diversification to learn more.

diversification

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One response to “Explain Diversification Like I’m Five Years Old”

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