Diversification
Diversity: Variety is the spice of life. Diverse choices on the buffet table make for a satisfying feast, because you can choose just what you want. When faced with the vast smorgasbord of financial instruments to choose from, this video lays out a recipe for making choices for managing risk, increasing your return, or both. The essential ingredient is diversity. In this financial context, that means owning different types of financial assets. Diversifying is a technique we can use to either reduce our risk, increase our return or some combination of both. We can accomplish diversification by holding diverse types of stocks. For instance, let’s assume we were only going to invest in two stocks: an umbrella manufacturer and a swimwear maker. Let’s simplify the weather into rainy and sunny. Those two conditions in our example completely describe all possible future economic scenarios for the two companies. If you only invest in the umbrella company, a dry summer with little rain would likely make your umbrella company stock perform badly. On the other hand, if you only invested in the swimsuit manufacturer, a wet rainy year would be a disaster.
We measure the risk of a stock by the standard deviation of the returns. Since stock prices tend to rise and fall within a range, predictably deviate up and down, we can set standards for how far above and below the expected return each stock will move. For normally distributed stocks, about two thirds of the time the individual returns will fall within plus or minus one standard deviation of expectations. What does that mean? Let’s say the expected (or average) return for both stocks is 10% and their standard deviation is 50%. We know that two thirds of the time the actual returns will be between -40% (10% - 50% = -40%)—that is, minus one standard deviation—and 60% (10% + 50% = 60%). That’s plus one standard deviation. That is a pretty broad range, and we will only be in that range two-thirds of the...