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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 Unfortunately, music streaming services made CDs seem out of date, and investors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
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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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41
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
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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.
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Spread It Around!
Name
DIVERSIFICATION ACTIVITY SHEET 1
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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.
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Can This Portfolio Be Saved?
Name
DIVERSIFICATION ACTIVITY SHEET 2
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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
Company Industry Size Domestic or International
Magnum Bank Financials Large Domestic
Gilmore Systems Technology Large Domestic
Ledman Applications Technology Large Domestic
TLT Dynamics Technology Large Domestic
GR Biomedical Health Care Medium Domestic
Ms. Jackson
Company Industry Size Domestic or International
LLL Electric and Gas Utilities Medium Domestic
TLT Dynamics Technology Large Domestic
Giant Manufacturing Manufacturing Large International
YY Products Consumer Goods Small International
Northwest Gas Utilities Large Domestic
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Can This Portfolio Be Saved?
Name
DIVERSIFICATION ACTIVITY SHEET 2
45
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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.
(Continues on next page)
Company Industry Size Domestic or International
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
GR Biomedical Health Care Medium Domestic
Crown Mining Materials Large Domestic
TLT Dynamics Technology 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
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Can This Portfolio Be Saved?
Name
DIVERSIFICATION ACTIVITY SHEET 2
46
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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.
(Continues on next page)
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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.
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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)