Episode #5 - Diversity, Diversity, Diversity
Thank you Michael Scott for sponsoring this episode of Winnings.
Intro:
Welcome (back)! We covered consistency last week, and to follow the baseball metaphor, you can’t have a team of only shortstops if you want to win the World Series. You need great performers at every position, which even gives some leeway for mistakes.
If you prefer a different analogy, an awesome school needs caring (and motivated) educators, great science specialists, a PE department that gets kids excited to be fit, caring nurses, top notch janitorial staff, and so on. In more recent times, organizations have started to acknowledge that one of the ways to develop a successful team comes from cultivating many points of view. A view from someone who might typically be from an “out group” can actually help a company’s bottom line - a lot. Think about that phrase “the whole is greater than the sum of it’s parts.”
How does this impact your financial nation of one (or a family)?
Simply put, it’s diversity.
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History:
Remember in Episode #3 where we discussed investing in the S&P 500? The brilliance that Bogle brought to the masses was that you don’t need to invest in one stock and go with your gut to “buy low and sell high” you could follow an entire index. A few years before Bogle pulled off his multi-billion dollar senior thesis (good luck to all those grads out there - I hope your theses are half as valuable), Harry Markowitz developed the Modern Portfolio Theory (it was for his PhD). Markowitz was amazed that when investors looked at different opportunities for their clients they didn’t consider the risk factor of the investments. Markowitz wrote this up in an essay called “Portfolio Selection.” Wild. As a reader of this newsletter you would agree: How could you not consider the risk?
Our friends at Investopedia share this tidbit about Markowitz’s work:
One of the reasons that "Portfolio Selection" didn't cause an immediate reaction is that only four of the 14 pages contained any text or discussion. The rest were dominated by graphs and numerical doodles. The article mathematically proved two old axioms: "nothing ventured, nothing gained" and "don't put all your eggs in one basket."
This is why I don’t do many charts in these letters.
Ultimately, the insight that Markowitz had was that you need to review your portfolio with an eye toward some form of balance between high-risk investments, think stocks, and lower risk investments, think bonds (if you can’t think bonds yet, I’ll cover them in a later letter).
You can only gain as much as you are willing to risk and the “balance” you see in your portfolio should reflect the risk you are willing to take. For the longer take on diversity, see this article, it also has a great planes/railroad teaching bit, which I like.
Takeaway:
You should take a look at a diverse portfolio. I’ve put a photo of one right here:
(Thank you to The College Investor for this wonderful chart.)
I’ve promised a few times that I’ll go into some of these different types of stocks, I will get there - promise. But for the takeaway, just see all of the options (these are just a few) that can protect you from downturns but also give you growth when the market goes up. The beauty of this model, as you’ll see in the Interact section below, is that you can invest with tools that will “rebalance” your portfolio with a similar timing mechanism as DCA. This way, if your US Large-Cap Stocks goes up to 30% of your pie, it will redistribute the winnings to other parts of your portfolio to protect you from a downturn on the US Large-Cap Stocks. This model continues until you’re ready to pull out cash for that house, car, or retirement.
One last takeaway that sometimes goes unsaid when understanding diverse portfolios is the impact of time. Even if you identify yourself as “risk averse” (read: “I hate rollercoasters; I don’t have a death wish” or “I’d never ask that person out; I will get rejected”), when it comes to your portfolio, your risk tolerance likely needs to reflect your biological age, not the fact that people think you have an old soul.
The benefits of the market can only be enjoyed if you are invested in the market. By definition it involves some risk mitigated by a diverse portfolio.
Interact:
One way to maintain a diverse portfolio is by using a robo-investor. Two pretty well-known ones are Wealthfront (which is what I use) and Betterment. They have pros and cons, obviously, but in many ways they take a lot of the thinking out of maintaining the diversity described in this week’s letter. For a quick 1:1 comparison, check out this site. If you have one of these accounts, please respond directly to this email and let me know. If you don’t and you get one, also let me know! Remember, you need to put money into the account in order for it to grow, not just open it :).