Diversification: A Cornerstone of Savvy Investing

When people talk about investing, it’s alluring to turn to the horror stories. 

“My dad invested everything in Bank of Ireland.  And just as he was about to retire, the stock plummeted.  He lost it all.” 

“Friends of ours inherited millions in a stock investment.  For years, they traveled as artists, living the dream.  Then the stock dropped to zero in the meltdown.  They lost their entire lifestyle and had find real jobs and forge careers in middle age!” 

These stories thrill us.  They make the stock market feel like a page-turner with startling plot twists: you have no idea what’s about to happen next. 

To the beginning investor, however, they’re a total turn off.  Since whole point of investing is to increase the value of your savings, why bother if you risk losing it all? 

What so many dramatic stories of loss have in common, however, is a total dependance on a single investment. 

Let’s take a look at why investors are smart to assume risk, but commit a fatal error if they fail to diversify. 

You Can't Play it Safe

Risk-free investments are a surefire way to avoid losing money.  With guaranteed FDIC-insured investments such as CDs and Money Markets, the government has your back even if the bank fails. 

Seems like a prudent route, right?

Well, not really.  The returns on FDIC-insured investments are so low they don’t outpace inflation.  And that’s a problem. 

Have you noticed how $20 won’t buy you the nice dinner out that it could in the 90s?  That’s right—inflation.  The spending power of $1 gradually falls each year; in the past twenty years, it fell by a yearly average of 2.2%. 

This means if you’d invested $1,000 into a 6-month CD during the same period, when the average return was 2.05%, the real return on the investment, which factors in inflation, would be negative .15%. 

Although the dollar amount of the $1,000 would have increased to about $1,500 over twenty years, its spending power would have decreased. 

In essence, then, FDIC-insured investments implicitly lose value.  They’re like taking the consolation prize at the Carnival Balloon Pop before you’ve even thrown a dart—you know you’ve lost at the onset. 

An investment needs a return well above inflation to make it worth your while.  And that means selecting assets not guaranteed by the FDIC—that is, assuming risk. 

Take the Risk and Get in the Game

It's easy to sit on the bleachers of life, eating popcorn and watching the game play out before you.  But it's not until you join in, risking a win or a loss, that the fun really begins. 

Be it moving across the country, running for office, risking intimacy with a friend, or pursuing a business dream, we reap the most fruitful harvests after assuming the greatest risks. 

Investing is similar: when you assume risk, you create the possibility for lucrative returns. 

Take the S&P 500 Index, for example.  It is composed of 500 businesses, all of which are vulnerable to changes in consumer demands, managerial decisions, and competition.  In short, inherently risky investments. 

Without a crystal ball, it’s impossible to know if an individual stock in the index will rise or fall.  Netflix, for example, rose an astronomical 4181% over the past decade.  While during that same period, Radio Shack filed for bankruptcy. 

Overall, the businesses in the S&P 500 do very well.  The index has an average return of 12% over the past 70 years!  An investor who selects stocks from amongst these businesses chooses wisely. 

So how to know which are the winners? 

The short answer is that you don’t.  Although investors research a company assiduously to discern if it's a buy, knowing for certain is an act of soothsaying well outside the realm of investing. 

In order to hedge against the risk of picking a bad apple, smart investors select an assortment of stocks.  On average, they know the value of the entire investment will rise. 

Lucrative investing, then, is a paradox.  By assuming risk, you're almost guaranteed some investments will lose money.  But it's also the only route towards receive a good return.  

What's Your Take?

Does the risk of investing turn you off?   Do tell! 👇

To read more about diversification, check out my white paper, "Diversification: A Cornerstone to Savvy Investing".