Imagine you have a two wheels in front of you, each with different possible outcomes - kind of like the Wheel of Fortune Game show, only each pie piece represents a different return on your money.
Your task is to choose which wheel you would like to spin and you will have to live with the randomly produced result listed on the wheel.
The first wheel represents purchasing a single stock. If you choose to spin it, there is basically a 50-50 chance that you will either make money or lose money. It is like flipping a coin. And among the winning and losing wheel pieces there is a great range of possible outcomes - from a loss of 50% to a gain of 50%.
The second wheel represents purchasing a mutual fund that holds many stocks. This time there is a better chance that you will make money because there are only two pieces that represent a loss. The range is a bit smaller - from a loss of 11% to a gain of of 35%.
Take a close look at the wheels and think about which wheel you would rather spin. And remember, this is not a game. This is your hard earned cash that you are investing!
Choose between:
- Wheel 1: One Stock- No Diversification
- Wheel 2: Many Stocks (Mutual Fund)- Diversification
The second wheel should be the obvious choice. By purchasing many stocks you have reduced your risk and increased your chance of a winning spin. As I mentioned earlier, you can go beyond this level of diversification by purchasing other mutual funds with different objectives.
- Wheel 1: One Stock- No Diversification
- Wheel 2: Many Stocks (Mutual Fund)- Diversification
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