Diversifying Your Risk

Now that you have learned a little bit about stocks and bonds and since we are on the topic of risk, let me go on to probably the number one issue you should address before starting: risk management.  You often hear that the stock market is risky and it is much better to put your money in a safe bank account.  However, I would argue that prepared correctly, the stock market is actually much better suited to guarantee a more prosperous future for you.  The main tool that you use to manage the risk you take on is diversification.

Let's take a simple exercise.  If I offered you the chance to play a game where I'll flip a fair coin, and if it lands heads you win $20 and if it lands tails you get nothing and the game costs $5 to play, how many times would you want to play it?  Probably as many times as you can.  Why?  Because the expected value of the winnings is $10 (50% * $20 + 50% * $0) and the cost to play is only $5.  Although technically, you should play the game even if you were only allowed to play once, it is much more assured that in the long-run you will make $5 on average each time you play.  Playing the game once is risky, but the payoffs when you do win should more than make up for the losses if you play many rounds.

The same can be thought of for stocks.  If you put your money into one stock and it happens to do poorly, you would have lost a lot of your savings.  However, putting your money into multiple stocks diversifies the risk, as if you were playing the coin flip game multiple times.  There is a more logical mathematical proof of decreasing the risk because variance of the outcome goes down as you increase the number of stocks you own, but I won't go into detail unless a lot of readers want to hear about it.  The main idea is to, like the old saying, not put all your eggs in one basket.

The main takeaway is that you are probably as diversified as you can be by having 30 or more unique assets that are different in terms of market capitalization, industry sector, and asset class.  I will go over these more in detail later on, but hopefully my example was clear enough to demonstrate how preferable it is to have a diversified portfolio when thinking about investing since you limit your exposure to the extreme cases and try to aim for a guaranteed return.  We will next take a look at how, as a whole, stocks have given a very consistent return on investment over the long-run.