We’ve been saying it since the 17th century, and it’s just as good advice today as it was then: Don’t put all your eggs in one basket. Drop the basket and you risk smashing all your eggs, and you’re left with nothing. But if you divide the eggs into a few baskets, you’ll still have some eggs left for breakfast if you accidentally drop one. As an investor, it’s important to make sure you don’t put your nest egg into one basket. Imagine an Enron employee who only invested in company stock. When the company went bankrupt in 2001, the poor employee would have lost their entire life savings and their job all at once. That’s why it’s essential to diversify your investments.
What Is Diversification?
Diversification is the strategy of spreading out your investments to reduce risk and smooth out the ups and downs of the market. To diversify properly, make sure to diversify between asset categories and within asset categories. The basic asset classes are stocks, bonds, and cash. Each class will have greater returns under different economic circumstances. Historically, stocks have a higher return over long time horizons – but are more volatile. If you’re investing for a short-term goal, it’s possible your stock might be worth less than the buying price when you want to sell. Bonds provide regular income and vary less than stocks, but historically have a lower return. Cash accounts are the safest of all but also return the least over time.
Diversify Between Asset Categories
To diversify between asset categories, you’ll want to choose a certain percentage of each asset according to your goals and your situation. This distribution of stocks, bonds, and cash is called your asset allocation. Consider two important things when making your decision: First, consider your time horizon. Do you want the money for a house payment in five years? If so, you’ll want more low risk, lower return assets. If the money is meant for retirement, include high return, higher risk stock investments to generate a larger nest egg. Second, consider your risk tolerance. Will you still be able to sleep at night if your investments drop in value? If so, how much of a drop can you take? Withdrawing money when your investments are down will decimate your investment returns.
Diversify Within Asset Categories
Just as it’s important to diversify your investments among different asset classes, it’s also important to diversify within each class. To diversify by location, consider how many international investments you’d like to make. This will help your portfolio continue to grow when the U.S. market is struggling. For stocks, think about owning companies of different sizes. Stocks are classified according to market capitalization or “market cap.” That’s the total value of the company’s outstanding stock in the market. It’s also important to own a wide variety of sectors, i.e. technology, energy, and more. For bonds, consider buying different types like government bonds, corporate bonds, and high-yield bonds. This will help your portfolio grow during many interest rate environments.
Make Diversification Easy with Mutual Funds and Exchange Traded Funds
Diversification sounds great, but how are you supposed to buy all those different assets? Mutual funds or exchange traded funds (ETF) are an excellent way to do exactly that. When you buy a mutual fund or ETF, you buy a collection of many stocks or bonds at once. Mutual funds or ETFs aren’t automatically diversified. For example, some funds might be focused on many companies from one sector. However, index funds are a type of mutual fund or ETF that is built to track the market. These index funds are a great way to own a diverse collection of stocks or bonds.
Diversification in Action
Let’s put this all together with an example. Say you’re in your twenties and have a high risk tolerance because you have a few decades before you want to touch your investments and nest egg for retirement. You might decide to put 90% of your investments in stocks and 10% in bonds. This is a great start, and you can continue diversifying your portfolio. You can allocate half your portfolio to US investments and half to international investments. One example of an ideal asset allocation might look like holding four different index funds: a total stock market index (45%), international stock index (45%), total bond index (5%), and international bond index (5%). Now that you know how to diversify your portfolio, focus on growing your nest egg — in more than one basket!