Book Two: Heartbreak and the Need for Diversity

We are asleep until we fall in Love!”

-Leo Tolstoy, War and Peace

Book Two of War and Peace is an emotional roller-coaster.  Prince Andrei returns from war and falls in love with the beautiful Natasha and they get engaged. Prince Andrei’s father makes them wait a year because he’s not sold (Natasha is the poor Count Rostov’s daughter).  With her marriage and life all but assured with Prince Andrei, Natasha then meets the charming and dastardly Anatole.  Anatole seduces Natasha, convinces her to elope, and then abandons her when their plan is discovered.  Natasha, having broken the engagement with Prince Andrei, is devastated.  Pierre, Prince Andrei’s best friend, consoling her after the engagement is broken, realizes that he is in love with Natasha.

Natasha had lots of options in men.  Because she had so many options, she eventually figures it out (but I won’t spoil it here)! Like Natasha, you want to have lots of options when it comes to investing (and maybe men too, that’s up to you).  And what I mean by options is diversification.  You don’t want to put all your eggs in one basket

The two pillars are investing are: risk and reward.  The higher the risk, the greater the reward.  A bond issued by a company on the verge of bankruptcy will pay a very high interest rate (reward!), but there is a high risk that it will also go bankrupt and you will lose all your money (risk).  Diversification is a way of lowering your risk while trying to maximize your reward.

The key to diversification is correlation.  I want investments that react differently to different market conditions.  Basically, I want to invest in different things, so that if one of my investments starts to lose money, I have one that still gains you money.

There are a couple ways to diversify. First, I can diversify within an asset class (i.e. stocks).  For example, I can buy several different types of stock.  If I buy an airline stock, a auto-maker stock, and a news company stock I am a little diversified.  If one company, or even one industry, starts doing badly, I still might have one or two stocks that do well!  The issue is, often, stocks move generally in concert with another (i.e. the whole market goes up, and then the whole market goes down).  Enter, option two.  I can also diversify across different asset classes.  I can buy stocks, bonds, REITs, gold, etc.  That way, if, for example, the stock market drops, my bonds or real estate investments will hopefully keep earning me money until the stock market comes back up.

The beauty of diversification is that it lowers my risk, but still allows me to keep my money in assets that earn me reward.  Here are just three examples of different types of assets out there.

Stocks: When you buy stock, you are buying shares in a company.  Investing in the stock market can be fun.  You can get super high rewards.  You can also lose a lot of money if the stock market crashes. The one thing to remember about stocks is, until you sell, you haven’t actually lost (or gained) any money.  And the United States stock market has, over history, only ever gone up.

Bonds: Bonds are basically loans. When you “buy” a bond, you are giving money to a person or corporation or government, and they are promising to pay you back within a certain number of years, plus interest.  The risk with bonds comes in two forms.  1) You run the risk that the person/thing paying you back will go bankrupt before they can, and you will lose your investment.  2) You run the risk that interest rates/inflation will rise, making the money you earn in interest relatively less valuable.  Just like stock, as with bonds, the higher the risk, the higher the reward.

REITs: REITs (Real Estate Investment Trusts) are an easy way to invest in real estate.  Essentially, REITs pool investors money together and buy commercial real estate.  You can buy in and get returns based on money those companies make off managing commercial real estate.

Buy buying a variety of stocks, bonds, REITs, I can hedge my bets, so that I don’t lose all my money if there is a catastrophe.

Check back next week for Book Three and my introduction into different ways you can invest in these assets and what happens when Napoleon invades Russia!

 

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