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Portfolio Diversification, Explained

We all know our portfolios are supposed to be diversified, but what does that actually mean?


The simple answer is that diversification in your portfolio smooths out your returns — your highs aren’t as high, and your lows aren’t as low. With that being said, there are still different levels of diversification.


At its core, a stock is really just ownership of a company, but I find that people tend to have a better understanding of small businesses than stocks. In order to illustrate the importance of diversification, let’s go through an example of a small business as a metaphor for a single stock:


Imagine you own a coffee shop in your hometown. As with all small businesses, you’re subject to a lot of risks, some of which are controllable, most are not. A few things that could negatively impact your business include:


  • People start moving away from your hometown, meaning a smaller customer base

  • People decide to start making their own coffee and don’t stop by your shop anymore

  • A weather event impacts coffee production, increasing the prices you pay

  • The entire world enters a recession — things are bad.


Let’s go through these one at a time. After each example, I’ll put it in terms of diversifying your portfolio with different stocks.


Population Relocation

Thankfully, your coffee shop is doing very well, and your sister, who lives across the country, has expressed interest in partnering with you to open another location where she lives. You decide to go into business together.


All of a sudden, you notice people are moving away from your hometown. Sure, your original business will suffer, but it’s unlikely that the same thing would happen to your other location at the same time.


Portfolio: Let’s say you started out with one stock - Ford. One of your biggest risks in owning only Ford is that people will stop buying cars from them, so you decide to buy GM as well. If people stop buying cars from Ford, it’s possible that GM will still be doing just fine, lowering your overall risk.


Home Brewing

The growth you’ve been seeing from the new location is great, but you’re looking to get into a different area of the business. You decide to start packaging the coffee you’ve been roasting in-house to sell from your shop and at grocery stores.


Now you have a more cost-effective option for your customers, and you’re still able to make money while they save by making coffee at home! It’s a win-win! Man, you’re good at this!


Portfolio: In addition to Ford and GM, you’ve now bought Goodyear’s stock - tires are important for cars, but they have their own idiosyncratic risks.


Pricy Beans

You’ve been having such success trying out new things that you decide to venture into a new, unrelated line of business. Your sister brought up the idea of starting a fine dining restaurant, and you decide to go with it.


Just as your restaurants start showing a profit, coffee prices rise, squeezing your coffee shop profits. Good thing you have a business that’s completely different!


Portfolio: You’ve just added Microsoft and Google - a couple of companies that are in a completely different industry.


Bad Times

Sometimes, you just have to weather the storm and wait for the good times to return. Your sister’s fine dining idea was great when times were good, but now it’s not looking so great. The coffee shops also aren’t doing well, but they’re not bleeding quite as badly.


Just because times are bad doesn’t mean you should throw in the towel though. You understand that over time, things will start to look better, so you hunker down and wait it out.


Portfolio: No matter how much you diversify with stocks, your portfolio will have negative returns sometimes. That’s okay. Manage your risk by holding cash for short-term needs and bonds for intermediate needs to avoid losses when you need the money.


Conclusion

When building a portfolio, diversification helps you avoid a devastating loss. You’re often going to own the losers, but it’s also the only way to consistently own the winners.

 

As always, keep in mind that you don't have to go it alone. Check out my website to see what it's like to work with me and reach out if you have any questions.


If you found this post helpful, help spread the word! Share with friends and family that you think may benefit as well. But remember, this is solely for educational purposes - it's not advice.

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