Jul 06, 2017

Question: Why Should Investors Diversify Their Investments?

This chart reminded why diversification makes a whole lot of sense (hat tip to Big Picture Blog for highlighting it):

Let me explain:

  • Each asset class is represented by a different color
    • Purple = Emerging Market stocks from developing economies like Brazil, Russia, India and
    • Blue = Small Capitalization (or Small Cap) U.S. Stocks
    • Dark Gray = International Stocks (from developed economies like Germany, England and Japan)
    • Red = Real Estate Investment Trusts (REITs)
    • Orange = Large Capitalization (or Large Cap) U.S. Stocks
    • Gray = High Yield U.S. Bonds (riskier)
    • White = AA Bonds (excellent credit) U.S. bonds (think bonds issued by companies like McDonalds)
    • Green = High Grade (HG) U.S. Bonds (between AA and High Yield)
    • Cash = Interest earned at typical savings account
  • The numbers in each box represent the investment return for that asset class in a given year (or half year in case of 2017) and the assets are sorted by year from best return to worst return.

Other ideas:

  • Enterprising teachers who love spreadsheets can have students analyze how much $100 invested in each asset class at beginning of 2003 had by June 30th, 2017 (maybe a future NGPF activity:)
  • Be sure to make the point also that investors can buy each of these asset classes with index funds. Can also combine these asset classes; for example, one can buy a bond index fund which includes all three types of bonds (HY, AA and HG) so you don’t need to buy individual funds.
  • The most difficult thing about diversification as an investor is the psychology of knowing that you can’t always pick the best performing asset class (for example, owning EM and International stocks didn’t work out so well for the past three years until the first half of 2017!).

Questions:

  • Just scanning the chart quickly, what asset class do you think was the best performing from 2003 – 1H 2017? What led you to this conclusion?
  • Did you find any instances where the best performing asset class in one year was the worst in the following year?
  • What is the range of returns in a given year (from best to worst return)? Take the leading asset class’s return in a given year and subtract the worst asset return for that same year. Do this for all of the years. What is the largest and smallest dispersion of returns (what you just calculated)?
  • With the answer above, is there a large cost to being in the wrong asset class in a given year?
  • Which asset class do you see tends to see the most dramatic shifts year to year? Why do you think this is the case?
  • Agree or disagree with this statement: You should try and pick the 1-2 asset classes that you think will do best and invest only in those.
  • How will this chart influence how you invest? Do you think diversification is more or less valuable after analyzing this data?

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Looking for a good investing activity to engage your students? Check out Ravioli Den which demonstrates to your students what impacts stock prices for individual companies.

 

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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