Happy Holiday Season! We hope you all had a wonderful Thanksgiving! I love Thanksgiving, it is the time of year where the house is cold and baking is fun (which is a funny statement coming from a non-baker). But as Financial Planner Scott DuMond states below, baking is a lot like investing. We hope you enjoy the first of this week's Monday Morning Quarter-Buck (a second one will be coming later today)!
Investing is Like Baking
Over the years, I have developed many stories, analogies and examples to teach financial concepts to my clients and students. For some reason almost all of the analogies are about food, and many of them about baking. This is one of my favorites that still helps me to keep my focus, even when the investment environment seems concerning. I hope you enjoy it too.
Making a chocolate cake is a lot like putting an investment portfolio together. First, you start with a list of ingredients that on their own, do not taste very good. Think about the ingredients in a chocolate cake.
Flour – I often get a bit peckish, but have never considered a few spoonfuls of flour as a desirable snack.
Sugar- Probably the only ingredient in the cake that taste good on its own.
Salt – Great on French fries, but again not so much by the spoonful.
Eggs- Short of Rocky Balboa and Napoleon Dynamite, I don’t know too many people that enjoy raw eggs.
Vegetable oil – No comment necessary
Baker’s chocolate – For those of us who actually have taken big bites of this, we know it is one of the nastiest, bitterest substances on the planet.
Vanilla Extract – Not something I would enjoy sipping on.
Baking soda/Baking Powder – One of my mother’s remedies for an upset stomach was baking soda in lukewarm water. Not a pleasant taste or experience.
As you review the above list, you may come to the same conclusion that I do. On their own, all of these ingredients have issues and none is enjoyable when taken individually. Quite frankly, if I were the baker none of these ingredients would end up in the mixing bowl! However, when mixed together properly and in the right proportions, something magic happens. We end up with some fantastic chocolate cake.
Now let’s review our ingredients in an investment portfolio:
Stocks – On their own, they are too volatile. The ups and downs of the stock market can make most of us nuts!
Bonds – They don’t make a whole lot of interest. Also, don’t bonds decrease when interest rates are going up? Aren’t interest rates starting to go up already?
Cash equivalents – Short-term investments like Money Markets and CD’s make almost no return. They certainly have no place in an investment portfolio.
Foreign securities – Don’t even get me started! Aren’t these the most risk of them all?
As we review the above list, we may come to the same conclusion as we did above. On their own, all of these investments have issues and none makes a whole lot of sense when looking at them individually. These investments on their own are also too bitter, too volatile too… Quite frankly, if I were the baker none of these ingredients would end up in the portfolio. However, when mixed together properly and in the right proportions, something magic happens. We end up with some fantastic portfolios.
This is the concept of “don’t put all of your eggs in one basket” or one of my favorite D words, diversification. The fact that when we mix these investments together with the right amount of stocks including large companies, small companies, midsize companies, international companies and bonds including corporate, government, long-term, short-term, international, we end up with a fantastic portfolio.
Every ingredient in a chocolate cake has its own issues and if I focused only on their negative attributes, I could never bake a proper cake.
Every investment in a portfolio has its own issues and if I focused only on their negative attributes, I could not invest in a proper investment mix or portfolio.
I may not be a baker or even understand why the ingredients mixed together give me such a good outcome, but I can still reap the benefits if I follow the recipe.
Even if someone is not an investment professional, they can reap the benefits of a properly diversified portfolio whether they choose to design it themselves after a model or get help from an investment professional. It is a fact that an expert investor and beginner will get the same returns if they have the same portfolio or mixture of investments and follow the plan.
Lastly, just like mixing and baking a cake takes time to get the proper result, it also takes time to let a proper investment mix achieve the expected returns. We cannot start removing ingredients or investments from our portfolio when they seem to taste bad. That would cause us to ruin our cake and ruin our investment portfolio. Instead of focusing too hard on any one ingredient or investment, we need to keep our focus on the big picture and give it time to work.