Diversification is the only free lunch in finance

You may remember that one of the BigThree Questions of Financial Literacy asks whether  it is true or false that "Buying a single company’s stock usually provide a safer return than a stock mutual fund.”

The correct answer is FALSE.

The reason why it is false is related to the concept of risk diversification:

1. Spreading an investment across multiple assets is known as diversification
2. The principle of diversification states that spreading an investment across multiple assets will eliminate some of the risk
3. It’s less likely that all assets will perform poorly at the same time.  When one performs poorly, another may perform well, and the two will cancel out
4. This is the financial equivalent of “don’t put all of your eggs in one basket”

Academic perspectives:

• Markowitz, H. (1952): In his groundbreaking paper "Portfolio Selection," Markowitz introduced the concept of diversification and its importance in reducing risk. He demonstrated that combining different assets into a portfolio could lower risk and increase the expected return compared to investing in individual assets
• Elton, E. J., & Gruber, M. J. (1997): Their work "Modern Portfolio Theory and Investment Analysis" further explored how diversification enhances the efficiency of a portfolio by spreading risk across different asset classes
• Statman, M. (1987): In "How Many Stocks Make a Difference?" Statman discusses the diminishing benefits of diversification as more stocks are added to a portfolio, emphasizing the importance of achieving an optimal level of diversification

Why is it important to set the example and teach your kids about saving? 

A very interesting paper* published on the Journal of Economic Psychology studies the effect of alternative parental teaching strategies on the propensity to save and the amount saved during adulthood. The authors find that parental teaching to save increases the likelihood that an adult will save by 16%, and the saving amount by about 30%.

Before sharing about the details of the research, I am launching a FREE 2025 Save & Invest Telegram Community to learn about upping your Saving game as well as to support and to be held accountable into your saving and investing plans for 2025. If interest apply HERE to be added!

This research paper presents three primary methods that parents can use to teach their children about saving:

1. Giving Pocket Money: Providing children with a regular allowance or pocket money is a direct way to introduce them to the concept of managing money. It helps them understand the value of money and the choices they must make regarding spending and saving.By giving children their own money, parents can teach them to prioritize and make decisions about spending versus saving. This method encourages financial responsibility from an early age, helping children learn about delayed gratification and the concept of saving for future goals. It also allows children to practice budgeting, as they learn to allocate their pocket money for different needs and wants over a period. Research shows that children who receive regular allowances are more likely to develop savings habits as they grow older, understanding the immediate benefits of saving a portion of their money for future purchases or goals.

2. Controlling Money Usage: This involves parents actively monitoring and guiding their child’s spending habits. It can include setting up savings goals or limits on discretionary spending to reinforce the importance of saving. By controlling how and when children can spend their money, parents can help instill financial discipline. This method teaches the concept of budgeting and financial self-control. Children learn the difference between needs and wants, and the importance of saving for significant future purchases. It also encourages forward-thinking and planning, as children begin to consider how their current spending might impact their future savings and financial goals. The control over money usage helps children understand the practical aspects of saving—how small, frequent expenditures can quickly add up to diminish their potential savings. This strategy promotes long-term financial thinking and better decision-making skills.

3.Giving AdviceAbout Saving and Budgeting: This involves parents offering advice, guidance, and discussions about the principles of saving and budgeting. Parents can educate their children on the importance of budgeting, setting financial goals, and the benefits of compound interest.Teaching children about the purpose of saving, how to set goals, and strategies to reach those goals fosters a deeper understanding of personal finance. It also promotes a proactive approach to managing money. Advice about budgeting helps children learn to allocate their money effectively, balance their income and expenses, and avoid financial pitfalls.Regular financial discussions can enhance a child’s financial literacy, preparing them for future economic challenges. These conversations help children internalize the importance of saving for long-term goals such as education or a car purchase, fostering a habit of planning and saving consistently over time.

The study suggests that the combination of these methods—giving pocket money, controlling money usage, and providing advice—proves most effective. Each method complements the others by addressing different aspects of financial education:

• Giving pocket money introduces the concept of money management and saving directly.
• Controlling money usage helps instill the habit of financial discipline.
• Giving advice about saving and budgeting reinforces the long-term benefits and strategies of saving.

*Bucciol and Veronesi, 2014, Teaching Children to Save: What is the Best Strategy for Lifetime Savings?,Journal of Economic Psychology

© Copyright, 2024,Elisabetta Basilico,@wealthmamma

You received this email as a customer or subscriber of @wealthmamma Click here to leave mailing list