Good morning, happy Monday & happy Martin Luther King, Jr. Day!
“The function of education is to teach one to think intensively and to think critically. Intelligence plus character – that is the goal of true education.”
Martin Luther King, Jr.
Let me warn you in advance, I might be getting a little nerdy here … I love this stuff and I hope you find it educational, insightful & helpful.
Diversification: what is it and why do we do it?
Diversification is quite simply the idea of “not all your eggs in one basket.” If I have all of my investments in a single stock then I am really betting my financial future on a single company. I think we all understand that to be unwise.
Of the 500 companies represented in the S&P 500 in 2021 the best performing stock was Devon Energy which gained 196.1%. Obviously, that is a crazy exciting rate of return. If I had $100,000 invested in the company on 1/1/2021 I would have $296,100 on 12/32/2021. Who wouldn’t want that? Absolutely amazing!
But … there’s more to the story.
Devon Energy closing price on 12/31 of
2021 = 44.05
2020= 14.89
2019 = 23.02
2018 = 19.71
2017 = 35.89
2016 = 39.33
So, if I bought Devon Energy stock on December 31, 2016, held it for 5 years, and sold it on December 31, 2021, I would have made 4.72 per share … roughly a 2.27% average annual return, including the massive gains made in 2021 (excluding any dividends). Had I invested $100,000 into that stock on 12/31/2016 and sold 5 years later, on 12/31/2021 I would have $112,007 (excluding dividends). All the sudden this individual stock does not look so attractive, huh?!
Let’s go to the other extreme. The worst performing stock in the S&P 500 in 2021 was Penn National Gaming which was down 42.9% in 2021. Ouch! That stock when from 86.37 on 12/31/2020 to 51.85 on 12/31/2021. What was that stock price 5 years ago (12/31/2016)? 13.88.
Had I invested $100,000 into Penn National Gaming 1 year ago I would have $57,100 (42.9% loss, excluding dividends).
Had I invested $100,000 into Penn National Gaming 5 years ago I would have $373,564 (26.65% average compounded rate or return, excluding dividends).
See the huge variations in stock values when we are looking at individual stocks? This is why I personally do not own a single individual stock and do not recommend my clients to own individual stocks. I would much prefer to spread out my risk over many companies instead of having my financial wellbeing in the hands of a single company, no matter how much I like the company.
The S&P 500 value on 12/31/2016 was 2,238.83, on 12/31/2020 it was 3,756.07, on 12/31/2021 it closed at 4,766.18.
Had I invested $100,000 into the S&P 500 1 year ago I would have roughly $124,050, not including dividends.
Had I invested $100,000 into the S&P 500 5 years ago I would have roughly $212,914, not including dividends.
So, we want to own more than one stock, we want to own dozens, maybe hundreds, possibly even thousands of different stocks. That is called diversification.
But there is so much more to diversification than just different companies. Of course, we will diversify across different companies, but we will also diversify into different industries, different company sizes, and different countries. In addition, we evaluate how the companies we invest in respond to all sorts of various factors including inflation, interest rate movements, political volatility, and currency fluctuations just to name a few.
Diversification is a very simple concept, but many layers deep on implementation.
Next week I plan on addressing international investing and why that is such an important component of properly diversified portfolios even though international investments dramatically underperformed the U.S. equities market in 2021.
But I think that’s enough for today 😊
Please never hesitate to reach out to me or my team if you have any questions or ways we can partner with you.