Diversification Cocktail
Many people took up a new craft during early Covid; mine was making craft cocktails. So, it is only natural that thoughts turn to mixed libations as a metaphor for investment diversification.
First, the basics. Asset allocation refers to how you arrange your portfolio among different types of asset classes – stocks, bonds, real estate, baseball trading cards, etc. Diversification refers to the range of differences within the asset class i.e., NY Mets trading cards vs DC Nationals, for example.
If you own a mutual fund or ETF that invests in the stock market based on a broad index such as the S&P 500, you are diversified, right? I mean, five hundred is a lot bigger number than one.
Imagine you are in a restaurant and are presented with its specialty cocktail menu. There are five selections, but for three of them, the base liquor is either rye, bourbon, or Scotch. They don’t taste exactly the same, of course, but at the end of the evening, they’re all whiskey. It’s not a terribly well-diversified cocktail menu.
So it is with the S&P 500. It’s 500 different companies…but over time, they all behave rather similarly to economic forces and the macro-level business environment. They are all large US corporations. They’re all whiskies.
For that reason, a well-diversified investment portfolio is stocked with some gin and vodka as well, perhaps a few flights of fancy such as amaro and, of course, a decent vermouth. Which is to say, not just an index fund that tracks the S&P 500, but perhaps the Wilshire 5000, which represents all companies in the market — small, medium, and large. Or a fund that tracks the Russell 2000, which represents small US companies. And an international stock fund to boot. Maybe even emerging markets for that kick of bitters.
Of course, just like blending the perfect (rye) Manhattan, taking all these seemingly disparate investment choices and crafting your ideal portfolio takes a bit of knowledge. Different types of stocks act differently “in the glass” (or your portfolio), which is the entire point of having them but also the source of some complexity. But just as you can master fairly quickly how to make a decent martini, you will find that confidently making investment choices actually requires only a modest amount of study but much more common sense (stir the martini, don’t shake it).
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