Financial Foundations: Power Of Diversification

Hi! I’m Nick, and welcome to Financial Foundations. I’m going to cover several concepts of investing that may seem confusing and show you that they’re actually simpler than you think. Let’s talk about the power of diversification.

So, what is diversification? Well, let’s say that you want to invest $10,000 of your money into shares of good companies with the goal of doubling your money in 10 years. According to the rule of 72, you’ll need to average a 7.2% return in order to achieve this goal.

So, what company should you invest in to make sure that you get that 7.2% return? Well, there’s no guarantee that a single company will actually average that return. There’s even a possibility that a single company could lose your money over that period of 10 years. It’s unlikely, but it could happen.

You see this pencil I’m holding? It’s pretty easy for me to snap it in half, isn’t it? Just like I can break this one pencil when it’s held by itself, investing in only one company can result in a much higher chance of you losing some or all of your $10,000 if that one company happens to “break.”

However, the idea behind diversification is that if you invest your $10,000 into several different companies, you have a less likely chance of losing money and a more secure chance of hitting your goal of an average return of 7.2% over the 10 years.

Going back to the pencil illustration, it’s nearly impossible to break a bundle of them bound together. Similarly, by owning a bundle of good quality stocks, it’s very difficult for your $10,000 investment to “break” or for you to lose all of your money.

That’s the power of diversification! Now, you may not make a killing by investing in the one stock that goes up 200%, but you also likely won’t get killed by investing in the one stock that goes down to 0. I’m Nick and thanks for joining me on Financial Foundations. I’ll see you next time!