The importance of diversification has been touted as an investment axiom since long before I got into this business. The logic behind it: Most investments don’t move together in the same direction at the same time. By having different types of investments—that are hopefully complementary to each other—one wrong pick may not have an overwhelmingly negative impact on the portfolio. Winners and losers will likely balance each other out, with the result being less volatility in the portfolio. You can explain the benefits of diversification by digging into a lot of equations on risk and variance, but I find using a lemonade stand as an example a little less boring.
If your portfolio were a lemonade stand
Let’s say I were 10 years old and want to start my own business. Setting up a lemonade stand in front of the house seems like a fun idea. On a nice, sunny day, a lot of people would be looking for a refreshing beverage and I can sell a lot of lemonade. I would be rolling in the quarters. But what if it were cold? What if it rained? It’s pretty miserable to be sitting out on the corner in that weather. Very few neighbors would walk by or want to buy lemonade. After spending my allowance on lemon juice, sugar and cups, and spending hours making the lemonade and building a stand, I would probably end up losing money. All while not having a lot of fun. My little business would likely only be profitable if the sun were shining.
Diversify for a rainy day
But what if I serve something else alongside the lemonade? Like a comforting cup of hot chocolate. With mini marshmallows on top! If the day is sunny and bright, I’m definitely going to sell a lot of lemonade, and maybe a few cups of hot chocolate. If it’s a cold and rainy day, I will sell more hot chocolate, and probably not as much lemonade. Essentially, I’m building some diversification into my business. Now I am going to be able to make some money no matter what kind of weather is thrown at me. That would give me more consistent cash flow for all of my candy and Pokémon card purchases.
It’s true that I won’t make as much money as I could have if I only had a lemonade stand on a hot day. But I also wouldn’t lose my allowance if it were a cold day and I only had lemonade to serve. The risk to my little business is lower, and the money I make more consistent.
I can even take things a step further and add something that people will buy on pretty much any day—like cookies. People always want to buy cookies, rain or shine. With three choices sitting on my stand, I have something for everyone. If it’s a nice day, I’d sell a lot of lemonade and not as much hot chocolate, but people would scoop up some cookies. If it’s a cold, miserable day, I’d probably sell a lot of hot chocolate and just a few cups of lemonade, but again, lots of cookies.
Why not just sell cookies?
Naturally you might ask: If it’s a nice day and people like cookies, and if it’s a cold day and people like cookies, why not just have a cookie stand and get out of the beverage business altogether? The problem is that cookies are a lot harder to make. I need to get my mom or dad to help me buy ingredients, and show me how to work the oven. And it takes more time and effort to make the dough and bake it, which ups my expenses. Bottom line, I don’t make as much on a cookie as I do on a cup of lemonade or hot chocolate. Cookies are a great way for me to balance my business and earn a more consistent amount of money. Yet having just a cookie stand would make me less money overall.
In many ways, these are the roles that different investments like stocks, bonds and cash play in a portfolio. Stocks are like lemonade. When the sun is shining and stocks are performing well, holding stocks can give you meaningful upside for your investment. But there are rainy days too. To help prepare for them you can add some hot chocolate, or bonds, to your portfolio. You may be giving up some gains by owning bonds, but you’re also building some cushion should stocks fall. And cookies are like cash. Cookies don’t have as high a profit or return as the drinks, but they can be a consistent, stable source of return under many weather conditions, much like cash’s role in a portfolio. Just don’t fill up on too many cookies because that can drag down the overall return of a portfolio. As with most things, moderation is key. Diversification may not always protect against losses, but a balanced portfolio that includes these three types of investments may be more insulated from risk and less impacted by market gyrations. Stocks, bonds and cash each perform differently in different markets, and each serves an important function in helping investors achieve their long-term financial goals.
Hopefully this tutorial helps explain why diversification is such an important concept when building a portfolio. Or at least it made you want to grab a snack. And if that’s the case, would you mind stopping by my little stand?