New Year's Resolution: Diversification [Part 7]

BreakingModern — “There is no such thing as a free lunch” — Unknown.

This is a famous saying which describes the generally acknowledged wisdom that you cannot get something for nothing — that there is always a cost that must be paid, even if it’s hidden from you. But there is another famous saying, one applicable to stock market investing. This saying describes an exception to the rule:

“Diversification is the only free lunch“ — Unknown.

Bread And Butter diversification

Spreading the Risk

Investing in anything is an inherently risky endeavor, but without taking on the risk you can never receive the reward. This is the principle that makes the market work the way it does. However, by diversifying the stocks you invest in, by spreading the risk across industries and sectors, you can mitigate the impact of your assumed investment risk.

It is important to understand that the stock market, in its most basic form, is a game with winners and losers. When you buy a share of Google (GOOG) for $400 thinking it will someday reach $500, you are buying it from someone else who thinks it will not, at least not in a timeframe they are comfortable with. In fact, there may be investors in the market betting Google will sell for less than $400 in the future. One side of the transaction is going to be wrong.

The “free lunch” of diversification means that you can spread your winning and losing possibilities over separate industries and investment sectors. Industries and sectors of industries do not trade in tandem — at least, not often. Just because the stocks of one industry are going down for a few months does not necessarily mean the stocks of another industry are also going to go down. In fact, the movement might be in the opposite direction. Like I said, there are always winners and losers.

White scales in front of clouds diversification

Back and Forth

For example, a properly diversified portfolio of investments may have stocks in sectors that trade in opposite directions depending on economic trends. At the time of this writing, the per-barrel price of oil is plunging toward lows not seen in years. This is bad news for many companies in the oil drilling industry but great news for consumers because the price of gasoline is now under $2 in many parts of the U.S. That means consumers have more money to spend on clothes, restaurants and trips to amusement parks. It also means trucking companies and airlines will be spending less money of fuel costs, raising their earnings and reaping other benefits.

A diversified portfolio could see the stock of Disney (DIS) rising as fast as the stock of Exxon (XON) is falling. Without this diversification, the falling price of oil could devastate your portfolio, but with diversification the impact is mostly neutral. And, since you are investing for the long term, you can wait out the temporary trends without raising your stress level.

This cause and effect, back and forth, up and down movement is how investors increase the value of their portfolios. In essence, this is the game you are playing when you invest in the stock market, and diversification is the tool you use to win no matter the situation.

Mitigate Risk and Thrive

Diversification is a key strategy for all investors, and it is the one strategy that must be followed and deployed without exception. If you do not keep a diversified portfolio of investments, you will likely suffer severe losses that your portfolio cannot survive. You will suffer the kinds of losses that will alter the course of your life and remove any hope you have for financial independence. Diversification is your only free lunch when it comes to increasing your wealth.

Also Read

Here are links to the other published articles in this series:

For BMod, I’m Mark W. Kaelin.

Note: The information provided is not intended to provide tax, legal, insurance, or investment advice. Risk is an integral part of any investment strategy and you should consult an attorney or tax professional regarding your specific legal or tax situation.