“Diversification is important in investing” is something you might have heard before. Diversification is the practice of spreading money between different investments to reduce risk. But why is it important to investing and your money?
You learned about diversification at an early age:
Eat your fruits and vegetables!
your parents would shout at you. Your parents wanted you to have a diverse, well-balanced diet.
- Diversification is important in your diet because it keeps you healthy.
- Diversification is important in investing because it helps your money make you more money.
Businesses practice diversification too
A coffee shop will sell hot coffee products and iced coffee products. During cold weather, it’s easier to sell hot coffee but harder to sell iced coffee. And when hot weather arrives, the reverse is true.
By selling both items – in other words, by diversifying their product line – the vendor can reduce the risk of losing money in any given season.
Don’t put all your eggs in one basket.
Why should you diversify?
If all your eggs (stocks) are in one basket and you drop it, you lose everything. However, if you have 10 eggs (stocks), each with its own basket and you drop one, you’ll still have nine eggs (stocks) left.
The sharp decline in stock prices in 2008-2009 is proof enough that putting all your eggs in one basket is a risky strategy. Individuals invest their money in different eggs. (Actually, you’re not buying eggs.) You’re investing in assets. The most common asset categories are:
- Stocks – help your portfolio grow
- Bonds – bring in income
- Cash – gives you and your portfolio security and stability
When I was a money moron, I bought several individual stocks. I thought I was diversified. WRONG! To make it worse, I bought stocks suggested by my friends and from following bad investment advice. A year or two later I sold the stocks for massive losses totaling $40,000.
The losses wiped out my retirement savings that I had spent years saving, and I had to start over.
The morale of the story – Learn about investing and diversification.
Diversification is important in investing because it reduces the risk of you losing a lot of your money.
Other asset classes
Asset categories for more experienced investors include:
- Real estate – a hedge against inflation and low “correlation” to stocks – in other words, it may rise when stocks fall
- Commodities – these include gold, frozen concentrated orange juice, pork bellies, oil, and gas.
Your home is not a dependable investment that will fund your retirement.
You may be able to sell your home for a big gain. As an investment strategy, it’s a gamble. Have an investment plan that includes high-quality, low-cost, no-load stock and bond index funds.
How can diversification benefit me?
Diversification spreads risks across many securities or stocks, so those that perform well offset those that do poorly. Though diversification protects you from devastating losses, it also costs you in average annual returns. That’s because risk and reward go hand-in-hand in the financial markets.
Anything that reduces your risk will also reduce your return.
Give yourself permission to take a little risk, unless you’re close enough to retirement that the additional security and peace of mind is particularly valuable.
Market risk: You can’t diversify away all the volatility of an asset class.
If you’re going to be an investor, you have to understand and live with risk. Investors get spooked and jittery when the markets are unstable. If you have a diverse portfolio you’ll lessen jittery feelings and anxiety.
You’re not shooting for the ideal holiday party guest list: all the guests get along, are polite, and well-behaved.
When you diversify, you’re targeting to gather assets that have nothing in common.
By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Diversification is important in investing because you’ll be more likely to stick with your plan and ride out the bumpy times.
Diversification with mutual funds
Because achieving diversification can be so challenging, some investors find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category.
A mutual fund is a type of investment where people pool money together and invest the money in stocks, bonds, and other financial instruments.
The investors mutually buy together what they could not afford individually.
Mutual funds make it easy for investors to own a small portion of many investments. A total stock market index fund, for example, owns stock in thousands of companies. That’s a lot of diversification for one investment!
Asset allocation
When you invest, you want to spread your money across the various asset categories. Spreading your money like this is called asset allocation. Asset allocation is the way you organize the investments in your portfolio between stocks, bonds, and cash.
By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.
Asset allocation is important because it has a major impact on whether you will meet your financial goals. If you allocate your money properly–for example, not all in one stock, but spread out across different kinds of funds, you won’t have to fear that a single stock could cut your portfolio’s value in half.
More than 90 percent of your portfolio’s volatility is a result of your asset allocation.
The process of determining which mix of assets to hold in your portfolio is a very personal one. The asset allocation that works best for you at any given point in your life will depend largely on your time horizon and your ability to tolerate risk.
Related: What is dollar cost averaging?
How much risk should you take?
If you don’t include enough risk in your portfolio, your investments may not earn a large enough return to meet your goals. For instance, if you are saving for a long-term goal, such as retirement or college, most financial experts agree that you will likely need to include at least some stock mutual funds in your portfolio.
On the other hand, if you include too much risk in your portfolio, the money for your goal may not be there when you need it. A portfolio heavily weighted in stock mutual funds would be a bad strategy for a short-term goal, such as saving for a family’s summer vacation.
(When saving for a short-term goal, such as a family vacation, open a new savings account, call it FAMILY VACATION, and make regular deposits into the account.)
Your age also plays an important role in your risk tolerance. Younger people can take on more risk because they have longer to recover. If you’re in your 50’s or 60’s and retiring in a few years, taking on too much risk can be a financial disaster.
Once you decide on a plan, sticking with it is important. People who change courses because of brief market corrections lose more money than those people who don’t.
There is no single asset allocation model that is right for every financial goal and every person. You’ll need to use the one that is right for you.
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