Investing Concepts: Diversification (Transcript)
Hey, everyone, I hope this video finds you well and making some fantastic money decisions in your daily life. I wanted to create a brief video just to talk about a concept that many of us hear all the time. It’s this idea of diversification.
And I think that a lot of us in the financial profession, or financial services, we use the word like diversification all the time. And we take for granted that people know exactly what we’re talking about. And so my hope for this video is to kind of create a concept, very, very simple idea to get a basic understanding of what diversification means and how it kind of helps people invest their funds, especially folks who have limited experience with investing (or just not really sure about what they should do).
Diversification can be a very powerful, powerful tool. So I put together a little sketch for you hope you like it, check it out. We’re going to try to cover this concept of diversification in a way that makes sense. But also very, very simple to under understand. Diversification is another big word that is commonly thrown out in the financial universe.
And to be honest, a lot of financial professionals, and personal finance folks, automatically just assume that everybody knows what diversification means. There are so many ways you can actually take a deep dive into diversification.
This is not a video for a deep dive. This is more for a basic, common-sense way to explain how diversification can work for someone. I’m going to use an example that I read in a book years and years and years ago.
And the example, or the initial framework of the example, isn’t completely mine but I have expanded upon it. If I could remember where I read this story, I would be glad to give credit where credit is due. So, if you know where this story originated, or who began this example, feel free to let me know and I’d have to be happy to plug a comment in the video giving them a credit or attribution.
Let’s talk about diversification. The way I like to explain this is I use a kind of a story or a framework that everyone can kind of understand. I’m going to use Betty’s beach stand, right, everybody likes to go to the beach.
Many people go to the beach, and you see dozens and dozens and dozens of stores and how people may use their merchandise. So, Betty’s beach stand originally starts out as a very simple concept. Betty decides she wants to go in business for herself. And she opens a beach stand at a very popular beach where many tourists come.
Betty decides that her primary focus is she is going to sell sunscreen. Her focus is I am going to sell sunscreen to the masses and make money and help everyone have a pleasurable, enjoyable beach experience. The problem that Betty learns is that not every day at the beach is sunny.
Sometimes it rains at the beach. So, Betty finds out that when days are sunny and hot, her sales of sunscreen are great. But when it rains, sales of her sunscreen go down.
When her weather is good and cooperative, she does well and makes money. But when it rains, she doesn’t do well and doesn’t make as much money. Also, we must think about seasons, as some places have a beach that gets cold in the wintertime and not as many people go there.
So Betty has this common problem. As a business owner, what should she do to make sure that she or she can stay in business, and that the downtimes don’t really harm her business? Betty needs diversification.
Betty must start thinking about other ways that she can diversify her offerings. So of course, Betty, still decides you know what, I’m going to still do sunscreen because I want sunscreen to be a key component of my business. But, there are days where it does rain, and I am going to start offering umbrellas.
So on days when it is sunny, she will have sunscreen. On days when it is rainy, she will offer umbrellas. She now has basically two main ways that her business can make money. And she realizes that the having the two components, where they offset each other a tiny bit, helps give her some stability with her business.
But yet, that is not enough. So Betty decides that she still needs more diversification to work with her business. Betty decides, Okay, I’m going to have, I am going to have a definite component of my business, a definite component of my business, that is going to be sunscreen, terrible art on my part, definite component of my business, that is going to be sunscreen because that is how I am known.
That is what I want to have, we’re definitely going to have a component of the business that is umbrellas, because we know that umbrellas can definitely be helpful. Plus, on a really hot day, you can use an umbrella for shade. But if the weather is nasty, and it’s rainy, people want to be protected from the rain, especially at the beach.
Betty decided that she still needs something that can help her have a competitive advantage with some of the other stores that people have options with. So she decided, You know what, I’m going to start offering, I want to start offering ice cream. And I’m going to have ice cream, be part of my overall offering soon.
Including with ice cream, I’m going to have cold drinks. So I’ll use red here because I’m a Coca Cola person. So we’ve got now we’ve got cold drinks. If you look at her pie, Betty’s pie, she’s got sunscreen, multiple selections of sunscreen, she’s got umbrellas for rainy days, we’re going to have cold drinks, for people who want to come in on a hot day and quench their thirst.
Or who doesn’t like to go to the beach and eat ice cream. So Betty has now started to build out her overall offerings of her store because she wants her store to do well and have the opportunity to do well or as well as possible in multiple seasons. Well, Betty continues to think diversification about what might make sense.
So she says, You know what, I’m not quite done yet. Betty thinks to herself—I need to have sunscreen. But I also I got to have to go along with sunscreen, I’ve got to have my, my cold drinks. Got to have those go along with the cold drinks, we are not going to forget about ice cream, and how important ice cream is to the mix.
We’ve got ice cream, cold drinks, and sunscreen for hot days. And for those not so nice weather days, we are going to add our umbrellas, we’re going to add a new offering, we’re going to add coffee, because who doesn’t like to sit down when it’s nasty outside, go out and have a nice cup of coffee? People can get out of the hotel, get out of the house, and have coffee.
And in addition to the coffee, we’re going to also offer some cookies. Now if you look at how Betty is running her store, Betty’s store has multiple offerings for people to be able to come into her store and have sunscreen if they need sunscreen, umbrellas, coffee, cookies, ice cream, cold drinks.
And then Betty says you know what else I’m going to do? I am also going to add an element of clothing and souvenirs. So what you look at, if you look at this diversification pie, it starts to look like a diversified investment portfolio. And that is essentially the core ideas behind diversification.
So, if you go back and look at Betty’s initial beginning, right, when Betty first had her store opening, she had sunscreen and she would live or die based upon how hot and how sunny it was (no diversification). If people were coming to the beach and they already had sunscreen, they didn’t need to go and see Betty.
If Betty’s beach or wherever she had her business had an unseasonably cool or unseasonably rainy summer time, she could really, really, really struggle. But what she’s done over time is Betty has slowly added more offerings to what she could do for people. If you look at Betty store, Betty has a little something for everybody. And we have opportunity for her to make money or to offer something, no matter what.
And each of these pieces are a little bit different for the other for from the other pieces. So she’s going to have seasons where maybe sunscreen doesn’t do that great. But her umbrella sales should be really good. If if ice cream is not doing so good, maybe coffee is going to be a place where she can make some money.
And so that is the idea or the core premise behind having diversification in your overall investment strategy is to be able to give you an opportunity to have some assets or some components of the portfolio that are doing well, even if other pieces are struggling. So that’s diversification 101.
I’ve tried to make it very basic and simple. I hope it makes sense.
All right. So hopefully, that made sense. I’m sorry, I’m not the greatest artist in the world. But I try to sketch things out and make it where it’s easy to understand. And that’s the goal is to try to build a foundation of a financial vocabulary with financial concepts that you can understand because, like anything else, like we want to we want to crawl before we walk, and we want to walk before we run.
And it’s not very helpful to you, if we just dive right into the deep end of the pool, and we’re talking about beta and alpha and all these complex concepts like variance and standard deviation, when we don’t have a core foundation to work from.
So that’s what we’re doing. We’re trying to create some foundational principles that you can easily understand go back to and reflect over time so that you can constantly be working on your own financial literacy. So hopefully that makes sense. Thank you so much for watching. If you if you don’t want to miss a video, please feel free to subscribe to the channel, and we’ll see you talk to you next time.