Basic Investing Building Block #3
By Steve Carlson and Jonathan McAlister
How can you reduce investment risk? Diversification! Diversification in investing is a technique whereby you allocate your money in different financial instruments, industries, etc. By doing so you reduce your risk by limiting your exposure to any single company. Simply put: Do not put all your eggs in one basket; instead, place fewer eggs in more baskets!
Now, you may be wondering how APC implements diversification into our investment philosophy. Well, we use both exchange-traded funds (ETFs) and mutual funds. Both investment vehicles are an excellent way to add diversification to a portfolio. Basically, ETFs and mutual funds are a basket of securities such as stocks or bonds or a combination of both. When you buy an ETF or a mutual fund, you essentially own a portion of that basket of securities. An ETF trades throughout the day on a stock exchange based on supply and demand versus a mutual fund which is bought or sold each day based on the Net Asset Value (the value of its assets minus liabilities) as of the closing price of the total portfolio.
Both ETFs and mutual funds have their place within our investment philosophy. The ETF and mutual fund securities we use have hundreds if not thousands of holdings within the fund. We believe, from a risk perspective, investing in ETFs and/or mutual funds is wiser than the alternative of investing in an individual stock or bond.
Let’s look at a couple of examples. Suppose you wanted a portion of your investment portfolio invested in bonds, and let’s say you live in Michigan (where Steve is from originally). With Detroit being the motor city, many investors in Michigan purchased General Motors bonds in the 1990’s and early 2000’s. Everyone knew and trusted GM. This was fine, until GM filed bankruptcy, and investors lost all of their investment. A diversified bond portfolio, however, would only lose a very small amount in that example as GM bonds would be a tiny fraction of the portfolio (probably well under 1%).
Or, let’s say you are considering what to purchase for the stock portion of your portfolio. Imagine the long list of bellwether stocks you could have purchased in the last few decades such as Sears, J.C. Penney, GM, Chrysler, MCI Worldcom, Enron, PanAm, TWA, Bear Stearns and Hertz (to name just a few). All have gone bankrupt. A broadly diversified equity fund, as with the bond example, would be anticipated to have a smaller loss (if any) since it would include many more companies.
The main point to take from all of this? Diversification is key to reducing risk!
For our next blog on investing building blocks we will discuss ETF/mutual fund expenses and where the optimal placement for different types of ETFs/mutual funds is for tax efficiency.