I really hope it’s not going to be a dry cold summer… I mean I’ll take the dry particularly if like me you have been dodging storms recently – happily with the terraces now open a cheeky G&T can be enjoyed while waiting for the rain to pass – and while wondering if I have time to run to the train or if I should just get a second drink it got me thinking about ice-cream and umbrellas being a good basic example for diversification….
Imagine you have invested into a shop that is open all year round but the only item you sell is ice-cream. We can guess what your profits will look like generally – low in the cold months and high in the warm months like the graph below.
The range of profits from our shop are not steady. Although we can expect higher returns when the summer months are warm – what if there is a cool summer? (Remember May this year) Your profits are likely to be even less to help sustain you through the poor months. “Your eggs are all in one basket”
For some people they may have lots of other shops and they do not mind specialising here. For others this would worry them, particularly if it is their only shop – if it rained all summer they wouldn’t be able to sleep at night.
So, for those that would be concerned, let’s diversify your shop a little. This means we are aiming to have a steadier return and set ourselves up so if we have unseasonal weather it won’t impact our shop as much. To do this let’s use a little investment theory. We will start selling something that is negatively correlated with ice-cream profits. This means generally speaking the expected movement of these will be opposite to ice-cream. This will bring the volatility of the profits down – decreasing the risk. You have already read the title, so let’s include umbrellas in your shop’s stock.
We can now reasonably expect a graph like this*:
* Now, I am sure some of you are thinking that you can use an umbrella to seek shade in the Summer or if you have a similar experience to me from your home country where juggling your ice-cream with your umbrella is just another June in the UK but hopefully you can see the point I’m attempting to make here….
The result is you have more steady profits throughout the year and even if you have a cold Summer or a mild Winter you are a little more protected through diversification as demonstrated by the red line in the graph below:
It is important that you understand how to structure your portfolio and the correlated risks within it. Most don’t have access to the tools that financial planners and independent investment managers do, therefore it might be worthwhile having a review of your own portfolio to see what correlated risks you’re exposed to. It could save you from a cold dry year when neither ice creams or umbrellas are particularly useful!