Monday, January 3, 2011

Diversify, Diversify, Diversify!

There is an old adage in real estate that the three most important things are "location, location, location".  For investing a similar admonition might go something like this:

Diversify, diversify, diversify.

Diversification is defined as owning a wide variety of different investments on the theory that a slump in one investment will be offset by gains in the other investments.  Obviously if you knew with certainty which stock or which investment is going to be the big winner, you would just buy that one particular stock or investment.  However, unless you have a crystal ball, you aren't going to be able to predict which investment is going to go through the roof.  Therefore, the next best thing is to hedge your bets and invest a fraction of your money in a little bit of everything. 

Here is a real life example of diversification in action...

Remember the crazy gas prices back in 2008?  During the summer of that year, gas prices peaked out at over $4 a gallon which pinched the wallets and pocketbooks of many Americans.  The average consumers weren't the only ones affected by this.  Companies big and small were also affected.  Companies which purchase and consume lots of fuel did worse than average; however, those companies that either supplied oil or other alternative energy did well.  Here is a sampling of some companys' stocks leading up to that summer (I also included the S&P 500 for comparison):

CompanyTicker SymbolIndustryPrice on 1/2/2008*Price on 7/1/2008% Change
S&P 5001467.971284.91-12.5%
Exxon MobilXOMOil94.1588.35-6.2%
ReneSolaSOLSolar Power12.2215.7629.0%
American AirlinesAMRAirline13.704.85-64.6%
* - ReneSola's price is from 2/1/2008 since it did not go public until January.

Exxon's stock price dropped by only 6.2%.  At first this may be somewhat counterintuitive since you would expect that Exxon would make a killing from high oil prices.  Note that the entire market went down by over 12% during this time due to the beginning of the recession and the financial crisis, so a loss of only 6.2% still beat the overall market.

ReneSola's stock price went up by 29% during this time.  The business case for alternative energy such as solar was bolstered by high gas prices.

American Airlines's stock price plunged during this time.  Airlines are major buyers of petroleum-based fuels for their airplanes, and because of the competitive nature of airline business, they are unable to pass along these additional costs to the flying public.

FedEx's stock price also dropped, but not quite as much as American Airlines.  Because there aren't as many shipping alternatives, they can pass along some of the higher cost of fuel to their customers.

Ford's stock price dropped by 30% during this time.  Ford and the other domestic auto markets were caught with their pants down because they had invested very little in the types of fuel efficient vehicles that consumers were demanding at the time.

As you can see, the shock of high gas prices affected each of these companies in different ways.  If you had invested in ReneSola, you would have been lucky that gas prices skyrocketed.  If you had invested in American Airlines, on the other hand, you'd be cursing the high gas prices.  However, when you were looking for investments back in January of 2008, you would have no idea that gas prices would go so high.  The only defense against a situation like this is to invest in everything:  large company stocks, small company stocks, US stocks, international stocks. 

Of course, you shouldn't invest in stocks alone.  When stocks were dropping in the last half of 2008, the bond market was booming.  If you held 100% stocks, you would have gotten crushed by the market.  However, if you had some money invested in bonds, your financial blow would have been cushioned.

The bottom line is that by diversifying your money, you are protecting yourself from unforeseen events which may batter an individual stock.  How do you diversify?  The most cost effective way is by investing in a good low cost index mutual fund from one of the big investment companies.  These allow you to "buy" the market with a very small minimum investment.  How do you determine how much to invest in each asset category?  Do I put 50% in stocks?  Higher?  Lower?  That question will have to wait for another day, unfortunately.

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