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Diversification Explained: How Investing is Like Making Salsa
Diversification is one of the most important pillars of investing. It’s a concept that’s simple to understand on the surface: essentially, don’t put all your eggs in one basket. Even though the idea seems straightforward, it can sometimes be tricky to grasp how it applies in practice, how one should invest their assets accordingly.
Diversification Explained: Why Investing Is Like Making Salsa
Diversification is one of the most important pillars of investing. It’s a concept that’s simple to understand on the surface: essentially, don’t put all your eggs in one basket. Even though the idea seems straightforward, it can sometimes be tricky to grasp how it applies in practice, how one should invest their assets accordingly. That’s why I love an analogy I learned in my graduate program from one of my favorite professors, Dr. Craig Israelson, creator of the 7Twelve Portfolio—he compared diversification to making salsa.
Let’s break it down.
Tomatoes: The Base of Your Portfolio
In salsa, tomatoes are the foundation. They make up the bulk of the recipe, just like US stocks often form the largest portion of a portfolio. These investments provide the base—the relative consistency and long-term growth potential—that portfolios need.
One thing to be cautious of is believing that a variety of tomatoes makes a diverse salsa. I've seen a significant number of clients who own a dozen different S&P 500 funds. Owning one (or maybe two, if there's a diversifying benefit, like being equally-weighted rather than market cap-weighted) S&P fund is sufficient. Owning a handful or more is just a salsa made of different types of tomatoes.
I also include a variety of US ETFs in my portfolio construction: tech, equal-weight S&P, mid-cap, and small-cap funds.
Onions and Bell Peppers: Adding More Staples
Next, you'd add onions and peppers to your salsa. These can represent international stocks—investments in companies outside the US that bring a different flavor (and opportunities) to your portfolio. This can also include your bonds, which add stability and help balance out the flavors of your portfolio. While they might not be as exciting, they play a critical role in making your mix well-rounded.
Cilantro: A Touch of Real Estate
Cilantro is one of those ingredients that makes salsa pop. In a portfolio, this could be your real estate investments. Real estate often provides diversification because it doesn’t move in complete correlation with stocks or bonds. It’s like a fresh twist that makes your financial recipe unique.
Other components I'd add here are: natural resources and commodities. Great diversifiers that have proven long-term benefits in a portfolio.
Jalapeños: Adding Some Spice
If you like your salsa spicy, you may want to throw in some jalapeños. These represent riskier investments, such as individual stocks, up-and-coming companies, or even Bitcoin. These can add excitement and potential for higher returns, but you’ll want to be cautious about how much spice you add. Too much, and you might find yourself struggling with the heat—or in investing terms, volatility and risk.
Habaneros: The Speculative Kick
For those who really love spice, you might go for habanero peppers. These symbolize the ultra-speculative investments—things like other cryptocurrencies, weed stocks, or niche investments that have the potential for huge returns but come with significant risk. Just like with habaneros, a little goes a long way. If you overload your portfolio with these speculative investments, you’re taking a gamble that may not pay off. There can be risk of losing your entire initial investment with these types of additions in a portfolio.
The Perfect Blend
The key to a great salsa is balance. You don’t want it to be overwhelmingly spicy, and you don’t want it to be bland. The same goes for your portfolio. Diversification is about creating the right mix of investments that align with your risk tolerance, financial goals, and timeline.
Some people prefer a mild salsa, which might translate to a portfolio with more bonds and conservative investments. Others love it fiery, meaning they’re comfortable taking on more risk for the potential of higher returns. No matter your preference, the important thing is that your portfolio reflects your unique tastes and financial situation.
How Do You Like Your Salsa?
Investing isn’t a one-size-fits-all process. Just like there are endless ways to make salsa, there are many ways to build a portfolio. The key is understanding what flavors you want, how much risk you can handle, and how to blend it all together to create something that works for you.
So, how do you like your salsa? Mild, medium, or spicy? Let’s talk about how to create the perfect financial recipe for your future!
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