The Big Picture of Diversification

The Big Picture of Diversification: A Lesson on the Golf Course

Financial PlanningA few years ago, I was out playing golf with some friends.  We had decided to play the Overland Park West course that winds through the upscale Nottingham by the Green neighborhood.  On this particular afternoon the weather was quite wonderful; 75°, slightly overcast, very light breeze, with mild humidity.  We began by taking our tee shots on the first hole.

As with any tee shot, you must always think about your second shot.  You must be mindful of trees, traps, hazards, and in the case of this course, houses.  The first tee is a long par 5, however, with a strong first shot you’ll give yourself a chance at hitting the green in two as there are no ball hazards near the green.

As I wound up my driver for my first shot, I took a mental note to stay to the left.  For beginners, there’s water all along the right side and to the left is a nice landing area in the fairway.  I struck the ball very well going little further left than I anticipated, but was still on the far left edge of the fairway.  I would have a chance to make it to the green in two with a strong second shot.

For my second shot, I chose to hit my 3 wood.  I planted my feet, tensed my grip, and mentally pictured my shot zipping through the air and landing on the green.  I really wanted to impress the rest of the group with a beautiful second shot.  And boy did I ever hit this ball hard!  I mean, I stepped into it and gave it all I had.  It was such a well hit shot, except for one small detail.  I had shanked it hard to the left and my ball was screaming towards the backside of a well manicured home about 250 yards away.  Note to the reader:  this particular home had one really big picture window overlooking the golf course.

As Murphy’s Law would have it, my ball smashed through the big, expensive picture window on the back of this home.  The rest of my group was stunned as they watched the ball pierce the window so effortlessly, leaving only a small hole near the bottom of the window.  I knew this was going to be a costly lesson.

As I drove closer to the home, a gentleman was walking back to the fence holding his poodle in one hand and my golf ball in the other.  He told us that he was sitting in his living room watching television, when suddenly, my ball broke through his window, bounced around his room, scared his dog, and finally came to rest under his tv stand.

As it turns out, he was the CEO of a large Overland Park company, and all in all, he was in good spirits about the entire experience.  We exchanged business cards and $745.94 later, he had a new window and the cheapest club in my bag, became my most expensive golf club.  On the bright side, it provided a great story and a good financial analogy.

You see, investing in the markets is very much like that big picture window.  You can decide to put all of your assets into one portion of the market.  However, if that portion of the market gets shattered, your entire portfolio- just like the picture window- is entirely out of service.  The lesson I’m highlighting here is one of diversification.

Look at the picture below and imagine, if that big picture window had been made up of nine smaller panes.  For starters, my lesson would have been much less expensive and when my golf ball broke through the window, only one pane would have needed replacement.

In the stock market, we represent these nine panes with the following breakdown:

If the market, let’s say, breaks down in the Small Cap Value portion of the market, you still have eight other areas where your money is diversified in the stock market.  This diversified portfolio is much better suited to weather the ups and downs of the stock market over the long run.

Over the years, I’ve seen investors commit a substantially large percentage of their stock investments to one idea (i.e. technology, foreign investments, gold, real estate, small caps, etc.) or just in one company.  The lesson to learn is diversification plays a key role in long-term wealth protection and wealth creation for your investments.  Or, more simply said:

Never own enough of one thing to make a killing in it;

Never own enough of one thing to get killed by it.

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