Beginner

Why Diversification is Important When it Comes to Investing

Diversification is often the battle cry for the seasoned investment guru. The experts tell us every day that we need to be diversified. They never tell us why we need to be diversified, and I’m pretty sure most of them don’t know themselves. We’re going to dive deep and give some real-world examples of how diversification will save your money and your future!

The Cardinal Rule – Don’t Lose Money

Warren Buffet, one of the greatest investors of all time, lives by 2 rules:

  1. Don’t lose money
  2. Don’t forget rule #1

Assets perform differently given certain economic climates and even times of the year. Retail stocks tend to do well during the fall in preparation for Christmas, while energy stocks have had a lot of their returns in Winter months. This is not guaranteed of course, and can even backfire on you.

Example 1: Acme Awesome Retailer

Summer is ending and we are looking at “Acme Awesome Retailer”. We think their stock is going to do well this fall, as they had a great holiday season last year.

You look into the company and see it’s expected to grow it’s sales 22% since last Christmas. You notice the stock has traded flat this year, so you jump right in.

The Christmas season comes and comes. Most of the children get 247% more toys than they need, and you have the same old fight with Uncle Roy at Christmas Dinner. You just can’t wait until Acme Awesome releases their numbers next week.

Next week comes and the CEO goes on TV an announces that increased competition resulted in fewer sales than last year.

Fewer sales than last year? The company was supposed to grow those sales by over 20%, not do less.

The stock opens the next day down 18%. Analysts downgrade the stock the day after, and it falls another 14%. You yell and get mad at yourself all the way down.

Level Up Our Investment

When you put all your money in one or a few companies, you are betting on the execution of that company to be perfect. Most of the time the stock market has priced the stock to perfection, meaning no room for mess-ups.

But what if it was a great holiday season? This stock might have paid off in a big way. Is there a less risky approach we could have taken to get the same results or close to it?

Example 2: Retail Sector ETF

Consider you didn’t do the all-in on Acme Awesome we discussed earlier but did believe it was going to be a great holiday season. You could buy an ETF (Electronically Traded Fund) that specifically targets the retail sector.

These ETFs have hundreds to thousands of companies in them, but for the sake of simplicity, let’s say they had five.

We already know how Awesome Acme did, and they are in our imaginary Retail ETF. Let’s look at the outcomes of 4 other fictional companies.

  1. Acme Awesome Retailer – Down 32%
  2. Barney’s Book Depot – Down 3.2%
  3. Too Damn Cold Jacket Co – Up 28%
  4. Only If You’re Good Toys – Up 37%
  5. Old Man Sports Ltd. – Up 18.7%

Look at the results from these 5 companies. Clearly, results can vary widely but if we averaged them all out we still get a positive return of 9.7%. That sounds infinitely better than the 32% loss we took on Acme.

In reality, if the retail sector was up 20% in sales year-over-year, an actual ETF with hundreds of stocks would reflect closer to a 15 – 20% return.

This would make us a solid return, but won’t help you with managing Uncle Roy at the dinner table.

Work the Globe

The balanced return looks great, but what happened if America wasn’t having a great year. The market always looks towards the future, so sales this year don’t mean sales the next.

Even if Acme Awesome had great holiday sales, if the market believed next year was going to be a down year, the stock would still trade lower. The best way to avoid this type of downturn is to work the globe.

I want you to think of 5 companies in your head. Don’t continue until you have 5 company names in your head. I bet at least 4 of the 5 names were companies in your country, or the country next door.

We are biased to only invest in what we can see on a day to day basis. Real estate investors buy properties near the place they live in. Most business owners open their business close to where they live. There is a 98% chance that neither of these is optimal, but we all do it anyway.

Example 3: Buying the World

Let’s continue with our idea of betting on retail (please don’t actually bet on retail). I’m going to make a new fund called “Global Retail ETF”. Here is what my fund will consist of:

  1. America Retail – Up 20%
  2. China Retail – Up 34%
  3. Europe Retail – Down 18%
  4. South America Retail – Up 14%
  5. India Retail – Up 27.4%

Most of the world did pretty well this year with their consumer spending. China and India outpaced the America retail market with a combined return of almost 30%.

As the years go by, some countries will do poorly and others will pick up the slack. There will be years when all countries all winners and years when all are losers.

Our money will be protected from the downswings of a single market, and continue to grow securely.

How Much to Diversify?

If you look back at Example #3, we had a few countries up really well, a couple of slow performers, and Europe struggling.

Human nature will get you thinking about avoiding Europe altogether. You think to yourself “just focus on China and America, they are doing great”. That’s true this year, and maybe next, but nobody knows for sure.

Years ago South America was doing really well, and many people believe India will outperform China and America in the future. Ten years ago, Europe was the place you went to for retail.

Times changes and the market acts quickly. By the time you notice the change, the market has already priced in the difference.

Don’t Forget The Cardinal Rule

Don’t lose money! This is the first and only rule you have to remember when investing. We already talked about it earlier, but it’s important enough to repeat.

When you don’t diversify your investments, you are setting yourself up to lose money. Anyone who says otherwise is riding on a cloud that is about to evaporate on them. Don’t listen. Stay the course.

Take-Aways

  • Making money is good.
  • Losing money is VERY VERY bad.
  • Markets go up and down but usually average out to a win
  • Nobody likes Uncle Roy