“Diversification, along with other financial instrumentation, will allow allocation of capital along the market continuum while improving earning levels when investing conditions lack equilibrium . . .”
Did that make your head spin? I made it up to prove a point.
The word “diversification” is one of those $20 words you hear on financial news shows. But unlike those TV programs, diversification is not hard to understand. Putting it into practice is pretty easy, too.
What Is Diversification?
Here’s a simple definition of diversification.
Think of the old proverb, “Don’t put all your eggs in one basket.” In other words, don’t put your hopes, dreams and future (or money) all in one place. Because if that resource fails, you’ll lose everything. So, in this situation, the eggs represent your money and the basket represents one type of investment (mutual fund, single stock, annuity, bonds, etc.). Virtually every financial advisor will encourage you to spread your money across different types of investments called asset classes.
Why Is Diversification Important?
Let’s say Jim and Pam both make $100,000 a year in their business. Jim’s money comes from three different clients, but Pam’s money comes from one client. What would happen to Pam’s income if the client she works for goes belly-up? Her only source of income is gone in an instant.
The same principle applies to your portfolio, which is another fancy term for all the places you’ve invested money. If you’ve put your retirement savings into one stock, what happens if that company goes under? You no longer have any money for the future.
Listen to me here: Nobody can predict what stocks will do on any given day. A tech company launches a new product and tech stocks go crazy. The same day, an oil rig crashes and energy stocks also go crazy—in the wrong direction.
That’s why you need to spread your money across different kinds of investments.
How to Diversify Your Investment Portfolio
The easiest way to make sure your investment portfolio is diversified is by putting your money into mutual funds. The good news is that if you have a 401(k), you’re already doing this! If you can’t participate in a retirement plan at work, then open an IRA (Roth if possible) through a broker or fund manager.
Now, once you open a 401(k) or an IRA, you’re not done yet. Your money will stay as cash in your account until you decide where the money should go. You’re given a list and description of your fund options. They all have different names (like Bank X Growth Fund or Group X International Fund), so don’t let that confuse you. You’re looking for four kinds of funds:
- Growth and Income. These funds bundle stocks from larger, more established companies. The goal is to earn you money without too much risk. These funds are the most predictable and are less prone to wild highs or lows. Typically, though, they won’t earn as much money as other funds.
- Growth. These funds are made up of stocks from growing companies. They often earn more money than growth and income funds but less than aggressive growth funds.
- Aggressive Growth. These funds have the highest risk but also the highest possible financial reward. They’re the wild child of funds. They’re made up of different stocks in companies that have high growth potential, but they’re also less established and could swing widely in value.
- International. These funds are made up of stocks from companies around the world and outside your home country.
To diversify your portfolio, you need to put your money across these four kinds of funds. That way if one type of fund (like international) isn’t doing well, the other three can balance it out. You never know which stocks will go up and which will go down, so diversifying your investments gives you the best protection against huge losses.
Now, the percentage of your money that you put into each of those four funds will be determined by two things: your risk tolerance and your time horizon (a fancy term for how much time you have until you’d like to retire). If you want to retire next year, you don’t want to put the bulk of your money in the riskiest funds. On the other hand, if you’re just starting out, you have more time to recover from any downturns in the market, so you can take on more risk.
What to Remember When Diversifying
Keep in mind that diversifying your investment portfolio is not a get-rich-quick approach for building wealth. Its goal is to soften the blow when the market drops. However, you can’t eliminate risk completely. The good news is that over the long term, your investments will pay off. That is, as long as you put away money on a regular basis and you leave it alone. Let time and compound interest work their magic.
Diversifying your portfolio is important, but you don’t have to figure it out yourself. Talk with your financial advisor about your options. If you don’t have an advisor yet, check out a SmartVestor Pro. These folks want to help you build wealth so you can enjoy the future of your dreams.
And, I promise, they won’t use any $20 words that nobody understands.
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