WTF Are Investments? Part 7: Account Types, Portfolios and Diversification

September 28, 2016 Paco de Leon

Here is a lesson (and not investment advice) on the different type of investment accounts and the importance (and definition) of an investment portfolio and diversification.

Wait... There are different types of investment account?

Some of you guys might already know this, but there are different types of accounts that exist in the investment universe. The last article in this series explained all the different types of investment tools and vehicles that exist like stocks, bonds and mutual funds. But those investments now have to be in an account. An account is like a container for the investments.

Here’s an example that might help. Let’s go way back to one of the first posts in this series and use the analogy that investment products are like frozen treats. For the sake of simplicity, let’s assume a stock is scoop of lemon gelato, a bond is a scoop of strawberry ice cream, and a mutual fund is that soft serve blend of vanilla and chocolate. So when you buy any combination of the scoops, they need to go inside of a container.

For this example a container can be a sugar cone or a cup or a waffle cone. Let’s go back to the real world. An account is a container. There are different types of accounts. A 401(k), 403(b), IRA and Roth IRA are all different types of retirement accounts. A brokerage account is an investment account that’s different than a retirement account because of when you are able to take your money out of the account. So the various account types have regulations that dictate how and when an investor can access their money.

What is an Investment Portfolio?

Investment portfolios are created to help investors reach their goals. The goals are determined by figuring out how much money is needed and when is it needed. Then a portfolio can be created. Portfolios are created by understanding the risk, return and regulations surrounding all the different investment products and accounts.

Sometimes an investment portfolio happens without someone realizing it. For example, let’s say Grizzly Mc Bear is a 37-year-old professional clown. He has been working his ass off and earning a great living because of the high demand for professional clowns. He buys a house that he lives in, has been contributing consistently to an IRA for the last 20 years, has ownership is clown business and has a pile of personal cash. All of those assets are part of Grizzly Mc Bear’s portfolio. And when Grizzly wants to diversify his investment portfolio even further, he begins to invest in fine art. More on that later.

A boring troupe in the investment world used to explain portfolios are pie charts. Pie charts get used because you can demonstrate portions relative to the whole. Sexy stuff, right?

Basic Portfolio Types

There are different portfolio types that are based on risk and possible return. For example, a conservative portfolio doesn’t take on high risk, but isn’t expected to have a high return. This type of portfolio will have a majority of the pie chart invested in conservative investments like cash and bonds. An aggressive portfolio has potential for a high return, but is risky. This type of portfolio will typically have more stocks, a riskier investment.

Portfolios are important because it allows you to get a high-level perspective on how your money is invested. Portfolios help you assess if your investments are inline with your goals.

What is Diversification?

Diversification is an investment philosophy and strategy. It is a way to ensure you don’t lose all your money because you’ve invested in one security. For example, let's say you invest $100,000 in Volkswagen. The company goes out of business and the stock is worthless. You lose $100,000.

Diversification helps you avoid a loss that painful by spreading out your investments across a diverse investment portfolio of different stocks, bonds and mutual funds. So even if you own Volkswagen stock and the value of the stock declines a lot, you don’t lose all your money because you don’t have all of your eggs in one basket.