A friend recently asked me about “portfolio theory” and why I talk so much about diversified investing. Basically, investment diversification is making sure that you balance the types and amounts of investments you have. And it’s absolutely one of the most important things any investor, at any stage of investing, should know.
But I also realize that it might not be all that easy for everyone to understand why diversified investing is so important. So I figured a few simple examples would be a good way to show you this principle in action.
Examples of how diversified investing protects you
Let’s look at some examples of how a certain stock affects the value of your investments. For our purposes, let’s say you have $10,000 total to invest. And there is a stock you love, called MYSTOCK — but it got really bad news.
Scenario 1: One stock only
In this case, you decided to invest all your money in MYSTOCK. It’s price was $20 a share when you bought it. But then the big news hits.
Turns out its splashy CEO embezzled funds and ran off to Tahiti with the head of accounting. Even though the company still has value, the news sends the price spiraling downward to $5 a share:
— Your portfolio value after the price fell: $2,500
— That’s a potential loss of $7,500 if you sell now!
Scenario 2: Diversified investment portfolio with 10 stocks
In this example, you own 10 stocks, evenly divided. Luckily, for our purpose, everything else holds steady. Just MYSTOCK tumbles. Now let’s look at the difference in the value of your total investments:
— Your new portfolio value after the price fell: $9,250
— That’s a potential loss of $750 if you sell now.
That’s a lot better than scenario #1.
Scenario 3: Diversified portfolio with stocks, bonds, & savings/CDs
Now you have a well-diversified investment portfolio, with stocks (40%), bonds (40%), and savings/CDs (20%). You have the same 10 stocks as you have in scenario 2. And once again, everything else stays the same.
So when the bad news hits this time, you feel almost no pain in the current value of your total investments:
— Your new portfolio value after the price fell: $9,700
— That’s a potential loss of only $300 if you sell now.
BTW, I’m not saying you should for sure sell in these cases. Here’s why …
Why it sometimes pays to not sell into bad news
Often, bad news sends a stock price tumbling. And then the psychology of “oh no … the sky is falling” takes over. Mostly based on fear and “me too” syndrome alone, the stock price winds up far lower than its true core value.
So before rushing to sell, breathe deeply and do a little snooping online. See what you can find out about the company. If the fundamentals are good, you may just want to hold the stock for a while and see what happens.
⇒ MORE: Should You Sell Your Stocks On Bad News? (article coming soon)
A few more thoughts
As you can see, not putting all your eggs into one investment basket is a smart move. That’s why diversified investing is so important. As tempting as it may be to just put everything into a few stocks, try to think long term.
It’s true that you decrease your chances of hitting it big quickly if a stock keeps climbing upward. But watching everything you own get cut in half or even go to zero isn’t worth the risk. A smart investor takes a little less, to increase their chances of winding up with more in the long run.
NOTE: For this simple example, I didn’t go into the extra balancing / diversification effects of having both bonds and stocks. Or the impact of funds, which are already diversified. Although two funds are more diversified than one, and so on.
But back to bonds … the very short explanation is that when stocks rise, interest rates may also rise. And the value of bonds may therefore decrease — even if your bond dividends remain the same. It’s just the way the math works. More on that here:
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