Imagine with me for a minute that you’ve been preparing to host a dinner party for some of your closest friends.
You sent invitations out well in advance and now, on the day of the dinner party, you have carefully set your dining room table with your best dishes and silverware. You’ve added fresh flowers to a vase and placed it in the center of the table.
You hear the doorbell and know your first friend has arrived. You welcome them and continue to greet your friends as they too arrive. Excited conversation and laughter fills your home. As everyone settles in you move to the kitchen to bring the food to the dining room, where everyone is assembling for the highly anticipated meal.
First, you bring out a large bowl of strawberries. You then carry in a large tray, also of strawberries. You say you have to run back to the kitchen to get the main course – a serving plate of strawberries. After everyone has finished eating, you announce that there is still dessert! This time, you bring out small, individual bowls for each person. As you place them in front of each guest, whether you can tell or not, they are disappointed as again strawberries are served.
Now, of course you wouldn’t serve the same dish for each course at a dinner party! But sometimes, people try to “serve the same dish” when it comes to investing.They try to pick the “winners” and invest in one or two or three – or even 30 – companies. They convince themselves they know better than the “experts” and can “time the market.”
BUT, the truth is no one knows what the market is going to do next. No one knows which stock is going to be the next Google. And even if we DID KNOW which stock to buy today, would we know when to sell out of it?
Now, you might be tempted to say Google isn’t going to stop growing. It isn’t going anywhere any time soon. But I think everyone reading this remembers the financial crisis of 2008. Did people expect Lehman Brothers to file bankruptcy? What about Enron in 2001? And these are just two examples.
When it comes to investing, the greater the risk the greater the reward – and the reward for investing is higher returns. But you don’t have to put all your eggs in one basket (or dollars in just a few companies). There is such a thing as unnecessary risk.
Instead, you can DIVERSIFY!
When it comes to investing you can ensure the failure of one company does not mean the failure of your entire portfolio*. By owning small pieces of the global market (a small slice of thousands of different companies), you can smooth out the volatility in your own portfolio, still experience favorable returns, and significantly reduce your investment risk.
You can diversify by owning a mix of stock and bonds, US and International companies, large and small companies.
One way to do this is through mutual funds**. For example, the Vanguard Total Stock Market Index Fund owns more than 3,600 stocks.
More on investing to come.
Today’s big take-away is this: You wouldn’t serve the same dish at a dinner party. Don’t serve yourself the same stock when it comes to investing. Diversify!
Until next time,
*Portfolio is just a fancy word for the combined total of all your investment accounts and the holdings you own in each of them.
**Think of a mutual fund as a package with a small piece of each individual company inside. Instead of investing in each of the companies individually, you can buy one mutual fund that holds all of them. Now, not all mutual funds are created equally. Some hold a few companies and some hold a lot. Some are very expensive to own and others are very inexpensive.