A Simple Guide to Diversification (Amateur’s edition)

Diversifi-huh? If that’s your first reaction to the word “diversification,” or you just don’t think it’s for you, don’t go running in the opposite direction quite yet. Because the truth is, it can be one of the smartest ways to help manage your exposure to risk as an investor. And here’s the good news: It doesn’t have to be as complicated as it may seem. This article takes the concept of diversification and breaks it down into a few small, digestible bites.

What on earth is diversification?

Basically, it’s a strategy of spreading your portfolio across a bunch of different kinds of investments, like U.S. and foreign stocks, bonds, and short-term investments (e.g., money market funds). The thinking behind it is simple: If you buy a mix of stocks, bonds, and funds, the mix of investments may help offset each other. So when one investment doesn’t do so well, other investments that might be doing a little better can help balance it out. Alternatively, if you put all your eggs into one kind of investment and it tanks, the losses could affect your portfolio in a big way. The goal of diversification isn’t to boost performance—it won’t ensure gains or guarantee against losses—but it can help set the appropriate level of risk for your time horizon, financial goals, and tolerance for portfolio volatility.

Why does it matter?

If you’re like a lot of investors, it can be tempting to check on and adjust your investments during market highs and lows. But timing the market can cost you. That’s why it is recommended that you set-up up a long-term mix of all different kinds of investments, and staying the course. As a well-known money manager suggests, “Being disciplined as an investor isn’t always easy, but over time it has demonstrated the ability to generate wealth, while market timing has proven to be a costly exercise for many investors.”

How do I diversify?

Consider looking over your investment mix (i.e., stocks, bonds, and short-term investments) to make sure it lines up with your investment time frame and risk tolerance. You may also want to take a look at different chart when allocating your portfolio, consider the return and volatility trade-offs of the different types of investments can help you achieve different levels of risk and return.

I have my mix. Now what?

Investors are encouraged to check in on and re-balance their investment mix at least once a year, or whenever your financial situation changes (think a job loss or a big bonus). Re-balancing helps you keep your risk tolerance at a level you’re comfortable with. So let’s say, for instance, your stock prices run up and your bonds go down. That extra stock could mean more risk for your portfolio.

THE BOTTOM LINE:

You’ve heard the age-old adage, “Don’t put all your eggs in one basket.” Sounds cliché, but it could be a smart move when it comes to investing. As John Sweeney puts it, “Choosing the right mix of investments, and then periodically re-balancing and monitoring your choices, can make a big difference in your outcome.” In short: Diversify. You’ll be happy you did.

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