Baking and Investing: Disciplined Approaches Work Best
My kids decided to make some cookies the other night, and it was very interesting to see three different and distinct approaches. My 17-year-old daughter was ready to mix everything quickly and get things done. She has always been a firm believer that more chocolate is always better; and attempting to prove her point, she dumped in a ton of chocolate chips. My 10-year-old son decided that all sugar was the same and rather than wait for the brown sugar, substituted granulated sugar (sugar is sugar after all). My 14-year-old daughter was fastidious in the preparation, measuring each ingredient perfectly. As you can imagine only one batch of cookies baked correctly and was edible.
Simplistically having a diversified investment portfolio is a lot like baking. Different assets are required in the "mix." Different "ingredients" are needed to maximize returns and minimize risks. Many investors do not understand the importance of using a diversified and correctly allocated portfolio. Some investors have no diversification, and some investors have naïve diversification, believing that the two or three mutual funds they may have in their portfolio are giving them proper diversification. Just as in baking, choosing the correct ingredients affords a greater probability of having the successful results.
Aggressive investors often want the sugar, the rush and the emotional high of watching a stock portfolio grow very large, very fast. These investors never stop to think that money can be lost. Conservative investors tend to use what they perceive as safer vehicles such as Certificates of Deposit as a main investment vehicle. Although CDs seldom lose principal, investors can lose purchasing power and can run out of money during their lifetimes. Proper asset allocation and diversification are important for all investors.
Diversification is the practice of using multiple asset classes such as stocks and bonds. The old adage of "not putting all your eggs in one basket" is especially true in investing. Diversification increases the potential for gains while decreasing the potential for lose. Asset allocation is the formula used to divide investment dollars into the different types of investment categories such as stocks and bonds, cash, real estate, etcetera. What percentage should be in stocks or bonds? How many cups of sugar or chocolate? The recipe will provide the answers.
An investment portfolio must constructed using a thorough understanding of one's financial situation and goals. There are many types of strategies and solutions that can be utilized in investing (there are many different recipes for cookies). It starts by conducting a thorough review of an individual's unique financial situation, understanding objectives and goals and then selecting the appropriate and diversified asset allocation approach or combination of approaches. An understanding of the economic drivers that are influencing the markets is also essential to help determine the target asset allocation mix. Multiple studies (most notably Brinson, Hood and Beebower) over the years have shown that asset allocation is responsible for 90% of the variance in portfolio returns. Investors today must know what type of asset allocation and strategy works best for their personal situation. And what works today may not work as well in the future. While no one strategy is best for everyone (someone wanting oatmeal cookies should not use the recipe for chocolate chip cookies), every strategy should include the correct diversification of investments in order to achieve the goals of the portfolio. The complexities of today's capital markets require tremendous capabilities to adequately construct a forward-looking asset allocation strategy.
Just as you would not substitute salt for sugar in a cookie recipe, substituting one asset class for another can have devastating results in an investment portfolio. The recipe for success, in baking and investing, should be understood and followed.
The Kids' Cookies:
- 1 1/2 sticks unsalted butter, cut into cubes
- 1/2 cup dark brown sugar, packed
- 1/2 cup light brown sugar, packed
- 1/2 cup granulated sugar
- 2 large eggs
- 1 tablespoon vanilla extract
- 2 1/2 cups all-purpose flour
- 1 teaspoon baking soda
- 1 teaspoon salt
- 1 cup good quality chocolate chips or chunks
Preheat oven to 350 degrees F.
In a large mixing bowl, combine cold butter, dark brown sugar, light brown sugar and granulated sugar with a hand mixer. Mix at slow speed for 30 seconds and increase speed until the mixture is fluffy, about 6 minutes. Lower the speed and add the eggs 1 at a time. Add vanilla and mix until all ingredients are incorporated. In a separate bowl, whisk together the flour, baking soda and salt. Add the flour mixture to the butter and sugar mixture in batches. Stir with a spatula until well blended. Fold in the chocolate chips or chunks and spoon the dough onto 2 parchment lined cookie sheets at least an inch apart. Bake for 14 to 15 minutes. Rotate the cookie sheet half-way through so that the cookies bake evenly. Remove the cookies from the oven and transfer to a wire rack to cool (OK that's a joke - in my house the cookies are eaten hot off the tray, never making it to a wire rack or plate. Just wanted to see if you were paying attention).
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