Most people think diversification simply means owning multiple stocks or mutual funds
In reality, a truly diversified portfolio will hold different investments and will potentially do well in different times
Most people think diversification simply means owning multiple stocks or mutual funds. In reality, a truly diversified portfolio will hold different investments and will potentially do well in different times. Diversification (Asset Allocation) does not guarantee a profit or protect against loss. Some may be expected to excel when interest rates are low; others when they are high. Some may be expected to excel when inflation is low; others when inflation is high. Some may be expected to excel when the economy is booming; others when the economy is in a recession. A diversified portfolio will never be the best performer in any given year, but it won’t be the worst either, and over time it should beat inflation and help grow and protect your wealth.
Imagine that a town has 4 shoe stores, all catering to women:
Shoe store #1 only sells casual shoes like flip-flops, slip-ons and sandals, etc. Shoe store #2 only sells boots. Shoe store #3 only sells high heels. In the summer and when the weather is nice, shoe store #1 does really well. But in the winter shoe store #1 can barely keep the lights on as the owner struggles to pay the bills. Shoe store #2 does really well when the weather is cold but struggles when the weather is nice and has to borrow money just to pay the rent during this time. Shoe store #3 does really well when the economy is good and there are lots of jobs, as their customers are either buying shoes for work or because they have the extra cash needed to splurge on some nice shoes. However, when the economy is in a recession, shoe store #3 struggles and has to dip into savings just to keep the doors open. Shoe store #4 sells last year’s fashions at a deep discount and does really well when the economy is lousy and shoppers are looking for bargains. But as soon as the economy picks up her store is empty and she has to lay workers off.
Now imagine that a 5th shoe store opens in town. It’s run by a very smart and savvy women and she decides to stock casual shoes like flip flops, slip-ons and sandals, boots, and high heels. She also sells last year’s fashionable shoes at a deep discount. In the summer, store #1 does the best, followed by store #5. In the winter, store #2 does best, followed by store #5. When the economy is booming, store #3 does best, followed by store #5. And when the economy is in recession, store #4 does best, followed by store #5. In any given season, store #5 will never be at the top when it comes to sales. But store #5 will also never be at the bottom, and faces much less risk of going out of business simply because of their diversified approach.
When presented in this manner everyone can understand why diversification makes sense. Yet when it comes to the stock market, people seem to forget why we don’t put all of our eggs in one basket.
When it comes to the stock market, people seem to forget why we don’t put all of our eggs in one basket
If you are unsure whether or not your portfolio is diversified, give us a call and we will analyze it for you.