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Diversification

5

LESSON 1

Diversification

Ever heard the old saying “Don’t put all your eggs in one basket”? That’s the idea behind diversification, which is really just another way of saying you should be putting your money in different types of investments to help reduce risk.

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Investment Choices, Part AHi! Nikki here! I’m 25 years old and already dreaming of the future: retiring to a beach house!

I’m relieved that I have a 401(k) account at work to help me save for the ultimate long-term

goal—retirement. I’ve been learning more about the stock market, and I think I’m ready to do

more investing. I went to Grandma and Grandpa’s for breakfast this morning to talk it over.

I asked if I should invest my money in Batt stock. After all, our sales have been growing, and the

share price of my company’s stock keeps increasing! But Grandpa pointed out that just because

the company is doing well now, that may not be true in the future, so it would be a bad idea to

invest everything in Batt. What if the company suddenly loses a lot of money? The stock would

go down, and I would probably lose lots of money too! He gave me a great example to explain:

There were once companies that had stores that sold compact discs (CDs). Their stocks were

very popular. Unfortunately, music streaming services made CDs seem out of date, and investors

in those companies lost a lot of money. Grandma chimed in to say that I’d be smart to diversify

(buy a variety of stocks) so that if one stock’s price drops, it won’t seriously damage my

finances. But how can I afford to buy a whole bunch of stocks? Grandma reminded

me that I invest in mutual funds in my 401(k) plan. Because each fund owns many

stocks, it gives me built-in diversification. It’s kind of like buying a premixed salad!

Diversifying your investments

by owning different types of

companies can help reduce

the risk of your investments

losing value when economic or

political events hurt a particular

industry or company.

WHAT’S THE

Big Idea?

Mid Twenties

Late Thirties

Diversification

5

LESSON 2

Diversification

When it’s time to invest your hard-earned money and help it grow for the future, you don’t want to make your financial future dependent on a single investment.

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Investment Choices, Part BAfter doing more reading on diversification, I feel like I should

talk to someone my age about where to start! Last night, I

called my sister April for more advice. She’s a doctor now, and

although she’s older than me, we have similar financial time

horizons. Plus, she’s really smart and has been investing for

several years! She loves to talk about money matters.

April said that since I’m 25 and have many years to deal

with the ups and downs of the stock market, it was okay to

invest in stocks for my long-term goals.

She wouldn’t let me off the phone without reminding me

of one more thing: If you use a mutual fund as part of your

diversification strategy, make sure to research the mutual fund

to understand the different types of stocks it holds. The last

thing you want is to have most of your money invested in one

type of company or industry. For example, if you only invest

in companies that make candy and they lose a lot of money

because bad weather wipes out the sugarcane crop, then you

will likely lose a lot of money, too, when their stock plummets.

However, if your investments are spread over different types

of industries and companies, such as technology companies,

health care companies, manufacturing companies, etc., then

your investment will be diversified, and your losses will likely

be less because the fund spreads your money across different

types of stock. Sheesh! This was getting super complex. I

decided to take notes on my laptop while April explained that

it’s important to have a mix of stocks (see next page):

ENTERTAINMENT

MANUFACTURING

MEDICAL

Mid Twenties

Late Thirties

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Mutual funds offer some

built-in diversification because

they have more than one stock

in them; however, there are

many different types of mutual

funds, and it’s important to

understand what types of

investments they hold.

WHAT’S THE

Big Idea?

INDUSTRIES

Sometimes events happen that help or hurt almost all the

companies in a specific industry. For example, if the price of oil

declines, many stocks in the oil industry could suffer.

STOCKS FROM DIFFERENT INDUSTRY SECTORS

INTERNATIONAL STOCKS AND DOMESTIC STOCKS

INTERNATIONAL AND DOMESTIC

Consider a mix of companies based in the U.S. and other

countries.

STOCKS OF DIFFERENT-SIZED COMPANIES

DIFFERENT-SIZED COMPANIES

It’s good to have a mix of funds with the stocks of small,

medium-sized, and large companies.

Wow, thanks for the info, April. Looks like I have a lot more research to do!

DIVERSIFICATION MIX

Spread It Around!

Name

DIVERSIFICATION ACTIVITY SHEET 1

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5

Economic ScenariosThe prices of stocks go up and

down for many different reasons. If a

company introduces an exciting new

product or has good earnings results,

the stock of that company usually

increases. The opposite happens with

bad news for that company.

Sometimes, news affects an entire

industry. If more people are buying

products online, the stocks of

companies that sell their products

through retail stores might decline.

Political unrest or a natural disaster in

one country might cause many stocks

located in that country to decline.

Then there are events that cause

most stocks to increase or decrease.

Prospects for good economic times

usually lift most stocks, while fear of

hard times depresses the price of

most stocks.

Because it’s impossible to know what the future holds, it is important to diversify

so that bad times for some companies don’t sink your whole portfolio.

This chart shows how mutual fund returns can change from year to year depending on factors such as economic conditions.

PERFORMANCE CHART

Type of Fund Year 1 Year 2 Year 3 Year 4 Year 5

Small Biotechnology Companies + 17% - 37% + 22% + 10% + 32%

Medium-Sized Airline Companies + 19% - 28% + 22% + 5% + 11%

Large Companies From Many Industries

+ 11% - 6% + 20% + 7% + 8%

International—Large Consumer Products Companies

+ 6% - 2% + 17% - 5% + 6%

Review the chart above, then read through the five scenarios

on the next page.

Spread It Around!

Name


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5

Year 1: All four funds had positive returns in a fairly stable market environment.

Year 2: The world entered a major economic recession, which caused a broad decline in global markets.

Year 3: Markets everywhere had significant gains, thanks to a broad-based global economic recovery.

Year 4: The U.S. experienced moderate economic growth, but other economies around the world declined.

Year 5: While all five funds had positive returns, the biotechnology fund soared, thanks to the introduction of exciting new biotechnology products.

Considering the industry fluctuations from year to year, explain why it is important to have a diversified

portfolio.

Answer Key: Answers will vary but should explain that the stocks of different types of companies perform differently depending on economic conditions. With a diversified portfolio, losses in some areas can be offset by gains in others.

Year 1 Year 2 Year 3 Year 4 Year 5

Economic Scenarios (Continued)

Read the five scenarios for each year,

and match them to the mutual fund

Performance Chart on the

previous page. Notice how

the economic scenarios

impact whether the returns

are positive or negative.

Can This Portfolio Be Saved?

Name


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5

Diversified PortfolioAs an investor, you want to make

sure that your stock portfolio is adequately diversified.

The stock portion of three

different portfolios is

presented on the right.

The stocks in the companies

they own are not spread out

among different industries

and don’t have a good mix

of domestic and international

companies, or a mix of small,

medium-sized, and large

companies.

Directions: Review the portfolios and consider how they can be more

diversified among different industries.

Now go to the next page and find a list

of recommended stocks to pick from.

(Continues on next page)

Ms. Mehta

Company Industry Size Domestic or International

LMN Pharmaceutical Health Care Small Domestic

NVM Bank Financials Large International

JL Therapeutics Health Care Small Domestic

Magnum Bank Financials Large Domestic

GR Biomedical Health Care Medium Domestic

Mr. O’Connell


Magnum Bank Financials Large Domestic

Gilmore Systems Technology Large Domestic

Ledman Applications Technology Large Domestic

TLT Dynamics Technology Large Domestic


Ms. Jackson


LLL Electric and Gas Utilities Medium Domestic


Giant Manufacturing Manufacturing Large International

YY Products Consumer Goods Small International

Northwest Gas Utilities Large Domestic


Name


45

5

Diversified Portfolio (Continued)

Directions: Use the Recommended Stock List to help diversify the

portfolios on the previous page.

Consider substituting up to three

stocks in each portfolio

to make sure that their

investments contain stocks

in different industries.

Remember, having a mix of stocks

helps minimize the risk of losing money

because your investments are spread

over several industries.



NVM Bank Financials Large International

Overlord Exploration Energy Small Domestic

LLL Electric and Gas Utilities Medium Domestic

Samson Development Real Estate Small Domestic

Giant Manufacturing Manufacturing Large International

Peter Networks Telecommunications Medium Domestic


Crown Mining Materials Large Domestic


YY Products Consumer Goods Small International

Ms. Mehta

These are the changes I would make to each person’s portfolio. (Explain your thinking.):

$$

$$

$$RECOMMENDED STOCK LIST


Name


46

5

Mr. O’Connell

These are the changes I would make to each person’s portfolio. (Explain your thinking.):

Ms. Jackson

Answer Key: Ms. Mehta’s financial assets are too heavily concentrated in the health care and financial industries. Consider subtracting JL Therapeutics, LMN Pharmaceutical, and Magnum Bank and adding three stocks from the following: Overlord Exploration, LLL Electric and Gas, Samson Development, Peter Networks, Crown Mining, and YY Products.

Mr. O’Connell’s financial assets are too heavily concentrated in large, domestic companies in the information technology industry. Consider subtracting Magnum Bank, Ledman Applications, and Gilmore Systems and adding three stocks from the following: Overlord Exploration, LLL Electric and Gas, Samson Development, Giant Manufacturing, GR Biomedical, and YY Products.

Ms. Jackson has a fairly diversified portfolio already, but her assets are too heavily concentrated in utilities. Consider subtracting Northwest Gas and adding one of the domestic companies.

Diversified Portfolio (Continued)

Directions: See instructions on page 45 to make changes to the

portfolios shown here.


47

Name

Show What You Know

5

DIVERSIFICATION ASSESSMENT

1. You have worked for a popular social media company for 15 years. During that time, you participated in the company’s stock ownership plan, and the value of your account now totals $600,000. This represents 80% of the value

of your total investments. The company is doing very well and expects to do well in the future. Are your investments

diversified? Explain the risk in this scenario.

2. What types of stocks should you consider owning to help you diversify your investments? a.) Large, medium-sized, and small companies

b.) Domestic and international companies

c.) Companies in a variety of industries; for example, health care, energy, technology, etc.

d.) All of the above

3. Why might an investor want to own stock in companies located outside the U.S.?

You don’t want your financial future to

be dependent on a single investment.

You’ve learned the concept of

diversification as a strategy to reduce

risk of your investments losing value

when negative events hurt a particular

industry or company.

Answer key: See next page.

48

Name

Show What You Know

5

DIVERSIFICATION ASSESSMENT

4. Why is it important to diversify your investments?

5. Why should an investor consider buying a stock mutual fund rather than buying the stock of a single company?

Answer Key: (1) The portfolio is not diversified, so some of the stock should be sold so that mutual funds in many types of companies can be purchased. (2) d. (3) To diversify. If the U.S. economy slows, economies of other countries might be picking up and the stocks of companies based overseas might be better performers. (4) To reduce risk. (5) If someone invests in one or even just a few stocks, then if those companies go bankrupt or lose value, the investor can lose a tremendous amount of money.

(Continued)

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