Diversification

Broaden Your Horizons

Diversification is a way to minimize risk by spreading out your total investment across different assets, such as stocks, bonds, ETFs, and real estate.

Why important

The purpose of diversification is to limit the risk that all your investments will lose value at once. If one investment loses value, your other investments should remain unaffected, keeping your overall losses to a minimum.

Protect your eggs!

Don’t put all your eggs in one basket, as the saying goes.

Diversification means investing in many different things, for example, investing in the stock market and owning rental real estate, so that the likelihood that you will lose money on all of your investments at once is reduced.

By putting your money in many different asset classes, or baskets, you spread out your risk. A downturn in the stock market or a bad investment pick may cause one of your eggs to tumble and fall, but the others should still be safely tucked away elsewhere.

Strategies

You can diversify in two key ways:

  • Invest in several different asset classes, such as stocks, bonds, or real estate.
  • Invest in different securities within the same asset class, for example:
    • Stocks from companies in different industries
    • Bonds issued by both foreign and domestic entities

How Diversification Works

Consider the two investment portfolios below. One is diversified into a number of asset classes, while the other contains only a single stock. Notice how the same negative market event has a very different effect on the two portfolios.

How Diversification Works

Sample portfolios

Aggressive Diversified Portfolio

  • Stocks: 40%
  • Bonds: 20% (maybe including junk bonds for the high-risk tolerant)
  • Active ETFs: 30% (return oriented, actively managed, not index based)
  • Cash or money market funds: 10%

Conservative diversified portfolio

  • Stocks: 15%
  • High-rated bonds: 40%
  • Mutual funds: 30%
  • Cash or money market funds: 15%

Double down on diversification

You can diversify your investments in many ways, but you don’t have to choose just one. The above example describes one type of diversification–investing in different asset classes to spread out risk–but you can further diversify by investing in foreign assets or by diversifying the specific securities you purchase within a single asset class.

For example,

Don’t just invest in several bonds from one company; select several stable companies to invest in, and buy some U.S. Treasury bonds too.
Include stocks from different industries and maybe a few foreign businesses as well.

By investing in a wide range of assets and then further diversifying by purchasing different securities within each asset class, you can diversify and protect your portfolio on many levels. The more diversification you have, the safer your investments will be overall.

Invest wisely

While diversification is important, you should still choose assets and specific securities that match your overall investment goals and current financial situation.

For example, diversifying into bonds is not a good choice if the only bonds you can afford are low-rated junk bonds, which trade at huge discounts due to the high level of inherent risk. Investing based on what asset is cheapest is rarely a good idea, so be sure your diversification choices are still prudent investments..

Key Points

  1. Diversification is a way to limit your overall risk by spreading out your investments.
  2. It’s unlikely that all your investments will lose value at once; diversification can help protect your money from market risks.
  3. You can diversify in many different ways, for example, choosing several types of investments (e.g., stocks, bonds, ETFs), and then choosing other specific investments for each type. You might also include foreign stocks or bonds.
  4. Don’t buy risky products just because you want to diversify. Always invest carefully.

Summary

Diversification is an important part of smart investing. By putting your eggs in several different investment baskets, you decrease the likelihood that a downturn in the market will kill your entire portfolio. While diversification is important, however, you should always choose investments that fit your budget and goals rather than diversifying for its own sake alone.

Fun facts

  • The concept of diversification as an investment strategy was first officially defined in 1952 by American economist Harry Max Markowitz as part of his Modern Portfolio Theory.
  • The word diversification comes from the Latin words diversus, meaning “turned in different ways,” and faciō‎, meaning “make do.” Diversification is simply the act of making something turn, or face, in different directions.

 

References

  1. https://www.sec.gov/investor/pubs/assetallocation.htm
  2. http://www.investopedia.com/terms/d/diversification.asp
  3. http://www.investopedia.com/articles/02/111502.asp
  4. http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/05/31/heres-why-diversification-matters
  5. http://www.investopedia.com/articles/basics/05/diversification.asp
  6. http://finance.zacks.com/portfolio-diversification-theory-6684.html
  7. https://en.wikipedia.org/wiki/Harry_Markowitz
  8. https://en.wiktionary.org/wiki/diversification

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