Warren Buffet is quoted as saying - "Diversification is protection against ignorance."
If I gave you the following options, which would you choose?
Option 1:
An 80% chance of making 3-4% and a 20% chance of losing 3-4% per year
Option 2:
A 20% chance of making 20%, and an 80% chance of losing all of your money
While this doesn't perfectly illustrate diversification, it does provide the basic idea. Diversification is the process of investing into multiple avenues. These avenues could be stocks, or different types of assets. Whichever method, diversification allows you to have much more security and opportunity to reach your long-term goals.
Let's start with assets. There are many types of assets you can own. Bonds, certificates of deposit (CDs), and stocks are some examples. Each of them have a different level of risk. Their risk however is inversely related to their rewards.
Bonds
Bonds for example can have some of the lowest risk, and some of the highest risk! This is because bonds can be treasury bonds, municipal bonds, corporate bonds, or even bonds on people!
Treasury bonds have the lowest risk as they are ensured by the government. You loan the government money in the form of buying a bond. As time goes on, the bond pays out interest in the form of coupon payments (say 1% a year of what you invested).
Corporate bonds however can be very risky. If the company defaults, and they owe you money, there is a possibility that you will not get your money back. Corporate bonds however provide you with a much higher return based on their riskiness, or grade. Corporate bonds are rated on a scale similar to grades. Investment grade bonds (named that as they are deemed safe to buy) are rated between AAA and BBB-. Non investment grade bonds can run down to D ratings. The possible return for an AAA (basically on the same level as the treasury bonds) is the 1-2%, while the possible return in the BBB- range could be 5% or higher.
CDs
CDs are similar to bonds. These lock up your money for a period of time in return for providing you back more money than you initially invested. The difference however, is that you can resell bonds and remove your position based on a market price. If you want to remove money from a CD before the maturity date (the date when the agreement ends), you have to pay an early withdrawal fee.
CDs are generally made through commercial banks which helps to make them less risky. As such, a typical CD could pay a 2% return. This is a good alternative to a savings fund, in which you know you won't need the money for x number of years and want to guarantee that it earns interest.
Stocks
Now, you've likely heard of stocks. Stocks epitomize the idea of diversification. Take two stocks, apple and snapchat. Apple has been a public company since December 12, 1980. When apple had its initial public offering (IPO), which is when it initially becomes available on the stock market, it opened at $22 per share. By the end of the day, the stock hit $29, a 32% increase! Snapchat recently had their IPO on March 2nd, 2017, and opened at a price of $17. By the end of the day, the stock hit $24.48 for a 44% gain.
Why did these stocks soar so rapidly? Simple. Uncertainty and risk. When both of these stocks had their IPO there was a lot of uncertainty about how they would do. Both were tech companies, one at the beginning of the tech era, and the other well into it. These technology companies are often risky as they require massive mainstream adoption and investment, and the environment is constantly changing.
Since Apple's IPO, its price has risen to $154.48. Snapchat on the other hand is down to $14.64. If you had invested in Snapchat at its high, you would have already lost nearly half of your investment, since March. If you had diversified however, while Snapchat may have decreased in price, other investments may have risen and your portfolio as a whole may be doing well.
Diversify to reach your desired risk and return!
I would be remiss however to talk about diversification without talking about an important concept, beta. You may have heard of Alpha, Beta, Gamma, etc. from greek life, science, or possibly finance. In finance, beta is the riskiness of a stock/company relative to the market. If you take every single stock of the market, and throw it into one portfolio, you would have a beta of one. A riskier portfolio would be higher than one, and a less risky portfolio, lower than one.
Why is beta so important? It allows you to invest at your desired risk/reward ratio! Are you a young millennial aiming to quick start your financial future? You might be able to take a little higher risk. However, if you're retiring and no longer have an income stream, perhaps you want to establish a portfolio with a lower beta.
So how do we manipulate beta? Well, there's multiple ways. One way may be to take two investments that are from different markets, say sporting goods and furniture. There's a problem with this strategy though as both could easily go down at the same time. How about we try the same market, but competing companies? Assuming that the market is perpetually increasing this can be a great strategy! Either they both go up, or one goes up and the other probably goes down since that one's going up. Still however, we run into the same problem with the possibility of the market declining.
The trick is to find negatively correlated investments. Correlation ranges from -1 to 1. A rating of 1 is a perfect positive correlation. When one moves, the other moves the same direction and the same amount. A rating of 0 is no correlation, they move completely independently of each other. This is similar to the first example above. A rating of -1 is a perfectly negative correlation. With this phenomenon, when one moves, the other moves in the opposite direction at roughly the same rate. This can allow you to capture the overall return of the market and minimize your risk.
If you are interested in learning more about this topic, I'll be doing a deep dive post onto this topic in the future. I'll be going through in greater detail about risk and how to use financial formulas and concepts to create a portfolio. I do not have an expected date for when I'll do this as it's a post I want to take my time with and prepare as detailed as possible, but please stay tuned if you're interested!
Mutual funds/index funds
A great way to gain the benefits of diversification easily is through mutual funds. Mutual funds are baskets of various stocks designed to limit your risk to one stock. Index funds can be mutual funds or exchange-traded funds (ETFs) and track indexes (hence the name). This allows you to track the market or index of your choice with more ease, but limits the amount of specificity you can include in your portfolio.
Don't be that guy
As you can see, there are many ways to diversify. Whether it be through different types of assets, or building portfolios, diversification is key to a long-lasting financial strategy. While you may experience short-term benefits of investing in a risky asset and making a decent return, more often than not it will turn out badly and result in major losses.
I am a member of multiple investing communities. In a Facebook group for one of these, I read a post which roughly read, "Tomorrow I will be draining my bank account and putting it all into AMD. I don't want to hear about why this is a bad idea, but rather why this may be a good idea."
It doesn't take a rocket scientist to tell you that there's a lot wrong with this statement. First, THAT'S HIS LIFE EARNINGS! If he's wrong, he's going to be in a terrible position. Second, he has confirmation bias, which is the bias to only topics that confirm his original thinking. He doesn't want to hear about the bad aspects of his idea, but rather only be told that he's doing well. Third, the stock that he is investing in is a very risky stock. AMD's beta is 3.16. That is a very, very high beta. In fact, in the S&P 500 this would rank as the second highest beta behind American International Group at 3.68.
Source: http://www.investopedia.com/stock-analysis/2011/sp-500s-highest-beta-stocks-aig-gnw-wyn.-hig-pfg-txt0503.aspx
Don't be the person who risks their life earnings in one investment. Take the time and find your risk/reward ratio.
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