You Too Could Build Your Own Cleveland Cavaliers
June 22, 2016
In honour of the Cleveland Cavaliers winning their first professional championship this past weekend, I wanted to take this opportunity to explain one of the most fundamental (if not the most fundamental) rules of investing: the importance of constructing a well-diversified portfolio.
We hear this concept all the time: “make sure you diversify.” But what does that really mean and most importantly, why should you care? Shouldn’t you just try to maximize the highest return possible? How else would you be able to afford that sweet car you’ve been dreaming about?
The answer to these questions is both yes and no. Sure we want to make as much money as possible when we invest, but how much risk are we willing to take? Simply put, the more aggressive (or more risk we take on) the greater chance we have of losing that hard-earned capital. The secret here is diversification – building a basket of securities that do different things in order to “spread our risk out.” With me so far? Good. Let’s dive into an example.
The Cleveland Cavaliers just made history. I can go through all of the records they just broke, but really there’s only one thing that matters: by all intents and purposes, they are the best basketball team in the world. Yes, they have a once-in-a-generation talent in LeBron James, but more importantly, they had specific pieces on the team that complimented each other so well. They had a masterful scorer in Kyrie Irving. They had a basketball grunt who did all the dirty work in Tristan Thompson. They had a steady two-way player in JR smith. They had trustworthy veterans who stepped up to the moment in Richard Jefferson and Kevin Love. The list goes on and on, but the point here is simple: they are World Champions because each individual on the team had a specific job to do, and while individually they might not be glamorous, when you put them together you have a true winner.
Building a portfolio for your investments is not too different. For many reasons you simply can’t have a team of LeBron James-es, just like you can’t have a smart portfolio full of Facebooks and Apples (recent performance aside). What you can have however, is a series of other securities who are meant to do different things really well – like generate income (bonds or dividend paying stocks), mitigate volatility (blue-chip value stocks) or securities that don’t sink when the market sinks (gold) – just to name a few. The underlying concept here is straightforward: while none of these types of securities are particularly attractive on their own, when combined properly in a portfolio – they can be game-changing. This “diversification theory” is anything but a theory – it’s rooted in award-winning logic from someone who was way smarter than me. If you don’t believe me – Google “The Efficient Frontier“!
Let’s take it to another level and examine this in actual practice. In an overly simplified example, let’s compare this year’s winning Cavs team to the one that came up short last year to see the importance of the concept. Facing largely the same opponent, one of the main reasons why Cleveland was able to come out on top this time around was the emergence of those “other players” we had discussed. LeBron went into Supernova Mode last year and it was not entirely close enough. This year while he did the same, the major key difference was that he had his specialized weapons along the way to help him out. Irving scored with grace when LeBron needed a break, Thompson gobbled up every rebound to allow the team to continue to push, and a handful of other guys made key plays when their backs were against the wall. Your superstars will do a lot of the heavy lifting most of the time, but in order to get to the next level, you need the rest of your guys to do what they best.
So, the next time you’re picking out your portfolio – make sure you don’t ignore those lesser, overlooked securities – those are often the picks that separates true champions from second place.
Jon is an enthusiast in both the investments and fintech spaces, with a keen interest and passion between the intersection of the two. He’s an active investor with an affinity for growth stocks and has been managing his own stock portfolio for the past 3 years. As a millennial who’s spent his entire career within the financial services industry, he believes that investing is the biggest kept secret in his generation. As such, he has made it his personal goal to lead the charge in hopes of infecting others with this same passion. His other hobbies include maintaining an active lifestyle, dangerously obsess over certain sports teams, and has an ambitious goal of visiting 30 countries before he turns 30. Jon is a graduate of the Richard Ivey School of Business, is a CFA Level II Candidate and currently works and lives in downtown Toronto.Feature image taken from foxsports.com