It Pays to Diversify

Have you ever heard the saying “don’t put all your eggs in one basket”? Well this saying holds true for your investments. When you invest, it is important to diversify where you put your money. Don’t put all your money in one stock, one industry, or one asset class.

You have $1,000 to invest. Where are you going to put it? Are you going to put it all on that hot new stock that’s expected to gain 50% this year? Or are you going to put some in that stock, some in less risky fixed income securities, some in a few other stocks, etc? The answer depends on your risk tolerance.

Your risk tolerance says how much risk you are willing to take. If you’re willing to risk it all to win big, you’ll invest it all in that new, hot stock. If this is your choice, you’re risk loving. In other words, you accept the chance you might lose everything you invested to make a huge profit.

If you’re willing to invest a good amount of your $1,000 in that hot stock, but you want to stay safe and invest a little in some stable stocks and/or bonds, you might be risk neutral. In other words, you’re willing to take some risk, but not too much.

Then there’s the scenario where you will only invest a little in that stock, if any. The rest of your money will most likely go in very safe stocks, and a lot of bonds, T-bills, etc. If this is what you thought of first, you’re most likely risk averse. This means you don’t like risk. You’re willing to give up some potential profit to keep your money safe. The tradeoff is that you have much less of a chance of losing your money!

This all ties into what’s called diversification. The more you spread out your investments, the less risk you have. Each individual stock still holds the same amount of risk, but your portfolio as a whole is now less risky. This is diversification.

The Benefits of Diversification

As already stated numerous times, the main advantage of diversification is that you lower your overall risk. Even if you invest in all risky stocks, the more you invest in, the less chance you’ll lose all your money. Be sure you spread out your money correctly though. We’ll talk about this more a little later.

Another benefit of diversification is that you gain knowledge of different industries, asset classes, etc. (depending on how you diversify). It’s always best to be a well-rounded investor. And diversifying forces you to learn about new things.

The Downside to Diversification

Don’t get me wrong, I’m all for diversification. But there is a downside. The downside is that you can’t make as much by diversifying. Consider this: if you diversify as much as you can by investing in the entire market, what’s the best return you’re going to get? The answer is whatever the market gains. You won’t be able to beat the market. (This is an extreme example, but it brings the point home.)

When you diversify, you’re going to have winners and losers. The losers are going to bring your portfolio down. But look at the bright side: you didn’t invest all your money in the losers!

Strategies for Diversification

Diversification doesn’t just mean picking a bunch of stocks and putting all your money into them. No, there’s more to it than that. Here are a few different ways you can diversify your portfolio:

• Different industries – Put your money into different sectors of the economy. Utilities are always stable (and usually pay good dividends). Tech stocks are good for some growth. Energy stocks add a little volatility (thus potential short-term profits). And so on. Don’t put all your money into one industry. If that portion of the economy tanks, so does your money.
• Different asset classes – You may not want to put all your money into stocks. (Or maybe you do.) You also don’t want to invest only in bonds. Put a little in both. Find other areas of the economy as well. If you have the money, invest in real estate, gold, other precious metals, etc. The more asset classes you’re invested in, the more diversified you’ll be.
• Different investment horizons – Stocks may be good for long-term wealth, but perhaps some shorter-term CDs will help you earn a little extra now while your stocks take a temporary dip. Take into considering both your short-term and your long-term financial goals.

Those are just a few methods to diversification. There are many more, which we will talk about more in-depth at a later point. But for now, keep thinking about different ways to spread your money around, and get diversified!