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Serving up diversification from a lemonade stand

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The importance of diversification has been touted as an investment axiom since long before I got into this business. The logic behind it: Most investments don’t move together in the same direction at the same time. By having different types of investments—that are hopefully complementary to each other—one wrong pick may not have an overwhelmingly negative impact on the portfolio. Winners and losers will likely balance each other out, with the result being less volatility in the portfolio. You can explain the benefits of diversification by digging into a lot of equations on risk and variance, but I find using a lemonade stand as an example a little less boring.


If Your Portfolio Were A Lemonade Stand

Let’s say I were 10 years old and want to start my own business. Setting up a lemonade stand in front of the house seems like a fun idea. On a nice, sunny day, a lot of people would be looking for a refreshing beverage and I can sell a lot of lemonade. I would be rolling in the quarters. But what if it were cold? What if it rained? It’s pretty miserable to be sitting out on the corner in that weather. Very few neighbours would walk by or want to buy lemonade. After spending my allowance on lemon juice, sugar and cups, and spending hours making the lemonade and building a stand, I would probably end up losing money. All while not having a lot of fun. My little business would likely only be profitable if the sun were shining.


Diversify For A Rainy Day

But what if I serve something else alongside the lemonade? Like a comforting cup of hot chocolate. With mini marshmallows on top! If the day is sunny and bright, I’m definitely going to sell a lot of lemonade, and maybe a few cups of hot chocolate. If it’s a cold and rainy day, I will sell more hot chocolate, and probably not as much lemonade. Essentially, I’m building some diversification into my business. Now I am going to be able to make some money no matter what kind of weather is thrown at me. That would give me more consistent cash flow for all of my candy and Pokémon card purchases.

It’s true that I won’t make as much money as I could have if I only had a lemonade stand on a hot day. But I also wouldn’t lose my allowance if it were a cold day and I only had lemonade to serve. The risk to my little business is lower, and the money I make more consistent.

I can even take things a step further and add something that people will buy on pretty much any day—like cookies. People always want to buy cookies, rain or shine. With three choices sitting on my stand, I have something for everyone. If it’s a nice day, I’d sell a lot of lemonade and not as much hot chocolate, but people would scoop up some cookies. If it’s a cold, miserable day, I’d probably sell a lot of hot chocolate and just a few cups of lemonade, but again, lots of cookies.


Why Not Just Sell Cookies?

Naturally you might ask: If it’s a nice day and people like cookies, and if it’s a cold day and people like cookies, why not just have a cookie stand and get out of the beverage business altogether? The problem is that cookies are a lot harder to make. I need to get my mom or dad to help me buy ingredients, and show me how to work the oven. And it takes more time and effort to make the dough and bake it, which ups my expenses. Bottom line, I don’t make as much on a cookie as I do on a cup of lemonade or hot chocolate. Cookies are a great way for me to balance my business and earn a more consistent amount of money. Yet having just a cookie stand would make me less money overall.

In many ways, these are the roles that different investments like stocks, bonds and cash play in a portfolio. Stocks are like lemonade. When the sun is shining and stocks are performing well, holding stocks can give you meaningful upside for your investment. But there are rainy days too. To help prepare for them you can add some hot chocolate, or bonds, to your portfolio. You may be giving up some gains by owning bonds, but you’re also building some cushion should stocks fall. And cookies are like cash. Cookies don’t have as high a profit or return as the drinks, but they can be a consistent, stable source of return under many weather conditions, much like cash’s role in a portfolio. Just don’t fill up on too many cookies because that can drag down the overall return of a portfolio. As with most things, moderation is key. Diversification may not always protect against losses, but a balanced portfolio that includes these three types of investments may be more insulated from risk and less impacted by market gyrations. Stocks, bonds and cash each perform differently in different markets, and each serves an important function in helping investors achieve their long-term financial goals.

Hopefully this tutorial helps explain why diversification is such an important concept when building a portfolio. Or at least it made you want to grab a snack. And if that’s the case, would you mind stopping by my little stand?

IMPORTANT INFORMATION: Matthew Tucker, Head of iShares Americas Fixed Income Strategy for BlackRock. This material is prepared by BlackRock and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of 28 November 2016 and may change as subsequent conditions vary. Issued by BlackRock Investment Management (Australia) Limited ABN 13 006 165 975, AFSL 230 523 (BIMAL). This material provides general information only and does not take into account your individual objectives, financial situation, needs or circumstances. Before making any investment decision, you should therefore assess whether the material is appropriate for you and obtain financial advice tailored to you having regard to your individual objectives, financial situation, needs and circumstances. This material is not a securities recommendation or an offer or solicitation with respect to the purchase or sale of any securities in any jurisdiction. BIMAL is the responsible entity and issuer of units in Australian domiciled managed investment schemes, including Australian domiciled iShares ETFs. BIMAL is the local agent and intermediary for non-Australian domiciled iShares ETFs that are quoted on ASX and are issued by iShares, Inc. ARBN 125632 279 formed in Maryland, USA; and iShares Trust ARBN 125 632 411 organised in Delaware, USA (International iShares ETFs). BlackRock Fund Advisors (BFA) serves as an advisor to the International iShares ETFs, which are registered with the United States Securities and Exchange Commission under the Investment Company Act of 1940. BFA is a subsidiary of BlackRock Institutional Trust Company, N.A. (BTC). BTC is a wholly-owned subsidiary of BlackRock, Inc.® Any potential investor should consider the latest product disclosure statement, prospectus or other offer document (Offer Documents) before deciding whether to acquire, or continue to hold, an investment in any BlackRock fund. Offer Documents can be obtained by contacting the BIMAL Client Services Centre on 1300 366 100. In some instances Offer Documents are also available on the BIMAL website at An iShares ETF is not sponsored, endorsed, issued, sold or promoted by the provider of the index which a particular iShares ETF seeks to track. No index provider makes any representation regarding the advisability of investing in the iShares ETFs. Further information on the index providers can be found in the BIMAL website terms and conditions at BIMAL, its officers, employees and agents believe that the information in this material and the sources on which the information is based (which may be sourced from third parties) are correct as at the date of publication. While every care has been taken in the preparation of this material, no warranty of accuracy or reliability is given and no responsibility for this information is accepted by BIMAL, its officers, employees or agents. Except where contrary to law, BIMAL excludes all liability for this information. Any investment is subject to investment risk, including delays on the payment of withdrawal proceeds and the loss of income or the principal invested. While any forecasts, estimates and opinions in this material are made on a reasonable basis, actual future results and operations may differ materially from the forecasts, estimates and opinions set out in this material. No guarantee as to the repayment of capital or the performance of any product or rate of return referred to in this material is made by BIMAL or any entity in the BlackRock group of companies. No part of this material may be reproduced or distributed in any manner without the prior written permission of BIMAL. © 2018 BlackRock, Inc. All Rights reserved. BLACKROCK, BLACKROCK SOLUTIONS, iSHARES and the stylised i logo are registered and unregistered trademarks of BlackRock, Inc. or its subsidiaries in the United States and elsewhere. All other trademarks are those of their respective owners. The views and opinions expressed in this article are those of the authors and do not reflect the official policy or position of NAB and nabtrade. Consider the appropriateness of the information in regards to your circumstances.