Buy All the Cookies
In The Beginner’s Guide to Investing – Part 2, we learned that the investing magic happens when the value of the stocks we buy increases beyond the price that we paid for them.
Whipping out our trusty cookie analogy, let’s say we bought 10 Oreo cookies for $5 each. That would cost us $50.
Let’s say a week later, Oreo cookies are selling for $6 each. We own 10 cookies that we paid $5 for, but now we have the opportunity to sell those cookies for $6.
If we sold our cookies we would earn $60, which is a $10 profit. Isn’t investing so fun?
But wait, there are like a million different types of cookies out there. How in the world are we supposed to know which ones to buy that are going to go up in value?
The cold hard truth is…
We’ve all heard the stories of people who bought a ton of stock in Facebook or Netflix or Amazon real early on and became a millionaire when the value of those stocks went through the roof.
But I guarantee you we only heard those stories after the fact. Nobody was doing headline news on those stock purchases when the companies were small little startups. Nobody knew those companies would grow to what they’ve become today.
A lot of people guessed…but nobody knew.
The truth is, it’s impossible to know which cookies are going to skyrocket in price, and for exactly how long. Even the best analysts on Wall Street have a hard time picking winners consistently, so what kind of shot do average people like you and I have?
That’s why it’s critical for us to own lots of different types of cookies. In the investment world this is called diversification.
Diversification – Buy All the Cookies
Putting all our investment dollars in the stock of one single company is way too risky.
Doing that ties our financial future to that one company. That’s not a very good investment strategy.
Companies can grow tremendously in value, but they can also lose value and even go bankrupt or go out of business.
Kodak was a great camera company, until it wasn’t.
Our investment portfolio should be well diversified, meaning we should have a whole bunch of different types of cookies in our cookie jars.
We should have Thin Mints and snicker doodles and oatmeal raisin and peanut butter cookies.
We should sprinkle in some lady fingers and Oreos and maybe even some double-stuffed Oreos!
In fact, our cookie jars should include over 100 different types of cookies! Maybe even 1,000 different types of cookies.
The problem is that we all have jobs and kids and bills and events to attend and lawns to mow. None of us have the time to do the research and pick that many different cookies in which we feel comfortable investing our money.
Mutual Funds – The Pre-packaged Cookie Variety Packs of the Investment World
Luckily, there are investments that do all the research and effort of buying 100, 200, 300 or more different types of cookies. And they package them into a single variety pack that we can buy.
These are called mutual funds.
Mutual funds are groupings of a large number of different types of cookies all bundled together and sold as single variety pack boxes.
For example, if I ran LYW’s Mutual Fund, I would have a team that does research on thousands of companies. Then we would pick the 150 or 200 that we felt are the most effective for the goal of the LYW Mutual Fund.
We would also choose how much of each cookie we should pack into our variety packs.
We may put more Thin Mints than oatmeal raisin and even fewer ginger snaps.
Then we would sell our cookie variety packs as a single cookie package at a single price. So you could buy 20 shares of LYW’s Mutual Fund and you’re actually getting 20 packs of 150 – 200 delicious (hopefully) cookies.
Diversify More by Buying Different Mutual Funds
From an investment risk strategy, just buying shares of LYW’s Mutual Fund is still way too risky. You’re completely dependent on me and my team to be smart enough to avoid doing something stupid, and as we all know, humans are prone to stupidity more often than we like to admit.
So our best bet is to have some of LYW’s Mutual Fund variety pack cookies in our cookie jar, but we’ll also want a few packs of ABC’s variety pack cookies and XYZ’s and even 123’s.
With this many different cookies in our cookie jar, if a single company goes out of business, it doesn’t really affect us because at this point we’re invested in like 700 different companies.
Even if one of the entire mutual funds has a bad few years or even goes out of business (which happens) we aren’t completely sunk.
We will live to eat cookies another day!
Yea for diversification.
Buying lots of different types of cookies lowers our risk. We never want to lose all our money when one cookie, or 10 cookies, have a bad year or all go out of business.
By owning shares in 500 to 1,000 different companies, we aren’t destroyed if some of those companies go belly up.
We also don’t have to guess which 5 or 10 companies are going to have explosive growth and turn into the next Apple or Facebook or Microsoft.
Any of them can be that next company and we’ll get to join in that ride.
Owning 700 Different Kinds of Cookies Sounds Expensive
That’s a great point. Price is very important.
While owning shares of 700 to 1,000 different companies sounds really expensive, there are ways to make it cheaper and accessible to the average person like you and me.
In Part 4 of the Beginner’s Guide to Investing we’ll look at how investment firms and financial advisors make money, and how we can make sure we’re paying a fair low price for our cookies.