We need some risk in our investments to give us high enough growth rates to become Financially Independent. However, if we don’t mitigate (or minimize) our risks our investments become little more than legalized betting. Diversification cuts investment risk by spreading the risk over many companies.
What is “Diversification?”
Diversification is a strategy that spreads investment risks over several different investments. You’ve heard the expression, “Don’t keep all your eggs in one basket.” The theory is that if you drop a basket that contains all your eggs, you’ll break them all. But, if you put a few eggs in several baskets even if you drop one basket you’ll still have most of your eggs.
Diversification does the same thing when investing in stocks. Instead of investing in one or two stocks, I recommend investing in a whole basket of them. Not only will this mitigate risks, it can help boost the growth rate.
The Risk of a Single Stock
Investing in the stock of a single company is very risky. It’s also very difficult to find that single stock that’s going to give you good long-term growth while still being relatively safe. Figuring out which stock has potential to grow for a long period of time is very difficult. You’d have to learn a lot about what makes companies successful and how to analyze a company’s potential. This is way beyond most investors, and certainly beyond what I recommend in this blog.
Everyone loves stories of people who became very rich by investing all their money in a company that went on to have record growth. But, for every Apple, Amazon, Intel, Microsoft, or Wal-Mart there are thousands of small companies that have stayed small or even gone out of business. The lure of a small company is that they have a lot of room to grow into a big company. A lucky investment in a small new company could result in a return of many times that investment. But, there’s a very high risk of losing all of your money.
Don’t fall into the trap of thinking that the company you’re considering investing in is a sure winner. They may have a killer product. But, there’s so much more to building a successful company. Management must make all the right decisions. Affordable financing must be available when they need it. They must have a product or business model that others can’t copy or improve on. The list goes on and on. The Motley Fool is a self-help investing site that has a list of 25 criteria they feel will determine if a company could be successful. You may decide that the risk of investing in smaller companies is too high so you’ll just play it safe and invest in larger, well-established companies.
It’s difficult to find a large company that’ll still provide good growth over many years. Many times, once a company becomes a success the price of the stock doesn’t grow much over time. Part of this is because by the time they are a large company most people are already using their products/services and it’s harder to grow their market. Also, it’s more difficult for many larger companies to adapt to new technologies and business ideas.
Large companies aren’t necessarily that safe either. Take for example the story of two different companies that were once part of the Dow Industrial Average—Sears and Kodak. Both companies were well-loved back in the 1960’s and 1970’s. With the huge buying power of the Baby Boomer generation coming the future for both big companies looked very rosy.
Sears was the top retailer in the country. I, along with other kids in my generation, looked forward to the day the Sears Christmas Catalog was delivered. Most of the kids I knew got toys ordered from that catalog. Besides toys, Sears was big in clothing, appliances, and automotive (Craftsman). But, they were slow to see the power of competitors like K-Mart, Wal-Mart, and then Best Buy and Amazon. Now, at a time when Sears expected to be on top of the world, they’re fighting to stay afloat (and losing).
Kodak was another great company. They sold memories in the form of cameras, film, developing supplies, and services for developing your film. Nearly everyone used and loved Kodak film. And, as with Sears, they were counting on big growth once the Baby Boomers started earning disposable income.
Then a most ironic thing happened. Kodak invented the digital camera. They quickly realized it would cannibalize their very profitable film business. So, they shelved the project and hoped it would die away. But, the genie was out of the bottle. Other companies began producing digital cameras and the rest is history. Kodak is now a small niche company that’s a shadow of its former self.
Even large, well-thought of companies can end up being bad investments. It’s hard to believe that current blue chip companies like Apple, Google and Amazon could be toppled like that, but they certainly can. 40 years from now I can almost guarantee that you will be able to look back and see where some of these companies made mistakes and fell out of favor.
Investing in a Basket of Stocks
You can cut the risks of owning stocks by investing in a basket of stocks. This is diversification. Your basket of stocks could include as few as 6-10 stocks, or it may have stocks in hundreds of companies.
An advantage of owning a basket of stocks is that you can only lose 100% of your money for a single stock. I know that sounds crazy. Where’s the advantage in that? This risk is more than offset by the fact that while you can only lose 100% of your investment, the amount you can gain is unlimited!
If you were to buy $1,000 of stock in a company the most you could lose is $1,000. But, you could gain much more. For example, Amazon stock is more than 200 times more valuable than when it was first offered. Your $1,000 invested there could now be worth $200,000! When you invest in a basket of stocks you may lose all your money in any single stock. But, you have many chances that another stock will do really well more than making up for the losers.
Say for example that you research and buy $10,000 of shares in each of 5 companies for a total of $50,000 invested. Over the years one company has gone out of business ($10,000 loss). The second company has done poorly and lost 50% of its value ($5,000 loss). The third company has roughly broken even. The fourth company has gained 50% ($5,000 gain). And the fifth company has tripled in value ($20,000 gain).
The fact that you lost $10,000 in the first company is gut-wrenching. But,the value of your basket of stocks has risen from $50,000 to $60,000—a 20% gain! The big gains of a just a couple companies may be enough to offset heavy losses of others.
To put your own basket of stocks together you’d have to learn how to research companies or find (and pay) someone you trust to research them for you. This is hard work and requires a lot of understanding in how companies become profitable. This is NOT what this blog is about. I want you to know how to become Financially Independent with the least amount of work and oversight on your part. This leads us to buy pre-built baskets of stocks.
S&P 500 – Our Basket of 500 Stocks
The basket of stocks that I recommend is an S&P 500 Index fund. The S&P 500 is an index of 500 or so of the largest companies in the United States. The share price of the index is a composite of the share prices for all 500 companies. On any given day shares of stock in some companies will go up while others go down. The composite price is a sort of average of all the stocks together.
The index is weighted by the size of the companies. This means that a few of the largest companies make up most of the value of the index. Only 10 of the 500 companies represent 20% of the value in the S&P 500. The 50 largest companies represent half the total value and the other 450 companies represent the other half. On average 25-30 companies that aren’t doing well are dropped from the S&P 500 index each year and new companies are added to take their place.
This benefits you. Instead of having a basket of stocks where losers are allowed to go completely broke, they’re replaced while they still have value. New companies are added and occasionally some of those new companies break through to become big winners. In other words, the S&P 500 automatically cuts their losses and guarantees that every winning stock over the long haul will be included in your portfolio.
When you buy a share of an S&P 500 index fund that single share contains fractions of shares in all 500 companies. When the S&P 500 makes changes to the companies that comprise the index your shares (even those you’ve already purchased) automatically reflect those changes. You don’t have to do a thing. The affected companies are dropped and new up-and-coming companies are added automatically.
S&P 500 index funds can either be sold through a mutual fund, or an exchange-traded fund (ETF). I prefer ETFs because their administrative costs and fees are much less than mutual funds. I recommend the Vanguard S&P 500 ETF, stock symbol VOO. Their extremely low overhead costs allow you to keep more of the money you make thus increasing your net growth.
When you buy shares in an S&P 500 index fund you’re investing in the United States economy. At times, our economy will go down and so the value of your shares will go down also. Once you’ve been investing for a while you may decide that you want to diversify even further by investing in companies that are not in the S&P 500.
The first place you might want to look at is international index funds. These funds are very similar to the S&P 500 index funds, but they’re made up of companies from all around the world.
For example, the Vanguard FTSE All-World ex-US ETF (stock symbol VEU) (meaning that US companies are excluded from this fund) is made up of stocks from approximately 2600 companies around the world. Many of the companies you’ll recognize—Nestle, Samsung, and Toyota.
While these companies represent economies outside the US you should understand that we now live in a “world economy.” This means that there’s a high correlation between how US stocks do compare with international stocks. It’s said that when the US stock market sneezes the rest of the world catches a cold. That means that the US stock market is so influential throughout the world that other markets are affected by how it does. Still, having some of your money invested in an international fund will provide additional diversification.
Whereas the S&P 500 is made up of mostly the largest companies in the US, there are thousands of other smaller companies that sell stock. Because these companies are smaller and not as well established as those in the S&P 500 this index is more volatile. This means that there are typically higher highs and lower lows than with the S&P 500. But there’s the potential for greater growth as this basket of companies are relatively early in their lifecycle giving them plenty of room to grow. As you might guess Vanguard has index fund ETFs for small (stock symbol VB) and medium (stock symbol VO) companies.
Why is This Important to You?
Diversification is an averaging of returns. A few losses are offset by a few bigger gains. The result will still have gains and losses, but they are less dramatic. You still have a risk of loss, but it’s not as great as with a single stock. Likewise, your opportunity for a truly great return is reduced, but the resulting average is still high enough to make you Financially Independent.
Picking stocks yourself is difficult and risky. The best way to diversify your portfolio is to purchase shares in an S&P 500 index fund. Once you feel the S&P 500 index fund is not diversified enough check out other baskets of stocks.
Share This with Friends and Family!
As you read through these posts, surely you may know of friends or family members who want (or need) to learn about Financial Independence. Use the buttons just below to share a link with them to this article through Facebook, Twitter, Google+, Pinterest, or email. Also, please comment on this post below. I’ll try to answer every question but, if an explanation takes more than just a couple sentences I may schedule a full post as a response. If you have suggestions for future topics leave those in the comments section as well.