This week, the creator of Marvel Comics, Stan Lee, passed away. In case you aren't familiar with Lee's work, he created or co-created some of the world's most popular comic book characters: Iron Man, The Incredible Hulk, Thor, Spider-Man, Dr. Strange, and Black Panther are just some of his creations. In honor of Lee's work, it seemed appropriate to revisit a basic principle investing, diversification.
You're probably wondering what comic book characters have to do with investing. Consider The Avengers, a team of superheroes who work together to save the day (most of the time). Individually, they can't succeed because each of them has strengths and weaknesses. Put them together and they are nearly unstoppable. Will there be ups and downs? Yes, but in the end everyone is better off working together.
When you invest, the concept of diversification works the same way.
What is diversification?
The short answer is that diversification means not putting all of your eggs in one basket. Iron Man is great. Seriously, who wouldn't want Tony Stark's brains, money, and sweet armor? However, when the fate of the world is at stake, as it always is, the odds of saving the day are vastly improved when Iron Man is assisted by Captain America, Thor, Hulk, Black Widow, and Hawkeye. If Iron Man gets knocked down another member of the team can step up and get the job done.
So how does this relate to investing?
Let's use Apple as an example of how diversification works in the world of personal finance. Apple is a highly profitable tech company. However, owning a portfolio comprised only of Apple stock is not a good long-term strategy. Let's say Apple's stock falls 20% because consumers stop buying iPhones. You won't be a happy camper if Apple is your only investment!
You need to create your own team of superheroes! Unfortunately, the team you'll create won't feature a giant green rage monster or a Norse god wielding a magic hammer. Instead, your team will be comprised of companies in different categories, such as Wells Fargo (financial services), Exxon Mobile (oil & gas), Pfizer (pharmaceutical), and Proctor & Gamble (consumer products). Why companies in different categories? Because it's impossible to predict which categories will be best from year to year. The following chart shows returns for different investment categories from 1998 - 2017.
Superhero portfolio assemble!
Okay, we've established why having one superhero (stock) isn't ideal. The following chart shows a hypothetical portfolio comprised of five superheroes (stocks). Please note the stocks referenced here provides a highly simplified illustration of how diversification works.
Spoiler: Instead of a 20% loss, you have a 3% gain.
Congratulations, your superhero stocks have saved the day! Instead of a 20% loss, you have a 3% gain!!
For the average investor, owning a portfolio of individual stocks, such as the one in the example above, isn't practical. Fortunately, mutual funds and exchange-traded funds (ETFs) provide investors with an efficient, cost-effective means of holding large baskets of stocks and bonds.
Owning one stock (or having Iron Man on your side) is great, but it's risky and could lead to losses (or the end of the world). On the other hand, owning multiple stocks in different categories (or multiple superheroes) typically reduces risk and leads to better long-term returns (or the world not ending).
I've just proven that reading comic books or watching movies based on comic books is not a waste of time. Thanks, Stan Lee!