How Diversification Decreases Risk

Last Updated Dec 10, 2010 3:48 PM EST


Part three in a series with videos that teach older kids about money:
Diversification is the key to reducing risk while staying invested through thick and thick, and for the long run. Individuals saving for retirement have a huge advantage when they start early, invest for growth (mainly stocks) and spread their investments around different industries and countries, and among both large and small companies. Understanding the role of a diversified portfolio is one of five core competencies needed to reach financial security, according to researchers at the Financial Literacy Center.

You can talk to your teens and adult children about diversifying their investments, especially as it relates to not owning too much company stock. Or for a simpler, proven approach show them this video:

Or invite them to read this narrative:

As she packs up her grandmother's china for storage, Kate holds up a bowl and reminds her brother Sam that she was always afraid of breaking it when they were kids. Kate and Sam both miss their grandmother, but they each need to decide what they're going to do with the money she left them. Kate tells Sam that she's going to invest her inheritance. She knows their grandmother wanted them to each have a nest egg for the future.
Sam recalls how their grandmother always said, "Don't put all your eggs in one basket." For Kate, not putting all your eggs in one basket makes good financial sense and she tells Sam that she's going to spread her inheritance money around.
At first, Sam doesn't understand why just putting your money somewhere safe isn't enough. But, as Kate tells him, when you're investing for the long term, you have to take some risk. Otherwise, there's no way to make your money grow because the average amount of money an investment earns over the long run is related to the riskiness of the investment. Riskier investments tend to make more money, while less risky investments tend to make less money. But that doesn't necessarily mean that riskier investments are better. With riskier investments, there's a chance you'll lose money; there's a trade-off between risk and return.
Kate explains to Sam that each asset in his portfolio, every investment he owns, will have some degree of risk. But what he wants to avoid is having a total wipeout and losing everything he owns all at once. For example, if he owns stock from only one company, then he is betting on the performance of just that one company. If it were totally destroyed, say, by a hurricane, his investment would be in trouble. An individual company can be struck by less dramatic difficulties, too. That's why it's important to invest in a mix of assets and not put all your money in one place.
Sam thinks about what Kate is saying, then tells Kate he's thinking about investing in the company where he works; the company is growing and Sam is confident they're doing well. Kate wonders if he's been listening to her at all. She tells her brother that the whole point of putting his money in a bunch of different assets is that if something unexpectedly bad happens to one of them, he'll be cushioned to a certain degree. But if Sam invested in the company where he works and that company tanked, both his job and his investments would be in trouble.
That's where not putting all your eggs in one basket comes in: you shouldn't have your investments and your job tied to the same company, and you shouldn't have all of your money invested in one company. Instead, spread it around.
Kate has Sam consider the following scenario: What if you invested in a whole bunch of companies, but they all manufactured umbrellas and all of a sudden, the value of umbrellas plummeted? That might sound unlikely, but think about when the tech bubble burst or when the real estate market crashed. It's smart to invest in many different kinds of companies and investments. Basically, you want the ups and downs of your investments to be as unrelated to each other as possible so that if some do badly, others will offset those losses. That's why it's a good idea to spread your investments across different countries, too.
Sam looks at his sister with a warm smile. She really is as smart as their grandmother. As they finish packing up their grandmother's china, Sam is already thinking about ways to go about keeping his nest egg of investments in lots of different baskets.
Research shows that these simple devices -- a video or narrative (both prepared by the Financial Literacy Center) -- will have a lasting impact on the financial knowledge and behavior of young adults who view or read them.

Photo courtesy Flickr user rmgimages
More video and narratives to share with kids on MoneyWatch:
More on MoneyWatch:
  • Dan Kadlec

    Daniel J. Kadlec is an author and journalist whose work appears regularly in Time and Money magazines. He is the former editor of Time’s Generations section, which was written and edited for boomers. Kadlec came to Time from USA Today, where he was the creator and author of the daily column Street Talk, which anchored the newspaper's business coverage. He has co-written three books, including, most recently, With Purpose: Going from Success to Significance in Work and Life. He has won a New York Press Club award and a National Headliner Award for columns on the economy and investing.

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