“Diversity” isn’t just a hot word in today’s politically correct environment. Used with some wisdom, diversity can be one of the best principles to guide your investing.
Perhaps you’ve heard people talk before about “diversifying your portfolio” — the idea is not new. The trouble is that unless you’re plugged into the world of finance and investing, it can be difficult to know what this really means. Well, consider this your introduction.
In this series on Wise Investing, we’ve been giving you some quick “do” and “don’t” tips that will help you as you invest for your future. We’ve talked about seeking out investments that have a long track record of success, and warned against pulling your money out just because the market goes down. Today’s lesson is another “do”: Do diversify your investments across a number of industries and approaches.
The word “diversity” always refers to having a mixture of distinct and different units as part of a whole, and that’s the best way to think about diversity in investing. We use the term “portfolio” to talk about the group of funds, stocks and other investment vehicles that you own as a whole. So when someone says that you should diversify your portfolio, what they mean is that you should make sure that you own a number of securities that are different and distinct from each other. In other words, don’t put all your eggs in one basket.
Why is it important to diversify your investments? Because it exposes you to lots of different areas and industries where you have potential to make money, and it protects you from losing everything you have if any one of those investments goes down in value. This is age-old advice that can even be found in the Bible. Check out what Ecclesiastes 11:2 has to say:
Invest in seven ventures, yes, in eight;
you do not know what disaster may come upon the land.
Solomon, the writer of Ecclesiastes, understood the inherent risks involved in investing, and knew that the best way to mitigate those risks was to spread his wealth out among a number of different ventures. A disaster that comes upon the land may wipe one or two of those ventures out. But since his investment was spread out among a variety of different companies, one disaster would not wipe his wealth out entirely.
That wisdom is still every bit as effective today as it was in Solomon’s time. If you find one stock, mutual fund or other security that is showing good returns right now, it can be tempting to put all of your funds there in order to maximize your profits. But that’s a foolish idea, because it puts your entire nest egg at risk. If that same fund or security begins to lose money — or folds entirely — then you will have lost everything. Spreading your investments out to a diverse set of securities may somewhat limit your capacity for radical gains, but it also protects you from staggering losses.
So, what does diversity look like? Well, if you’re investing in mutual funds, it means allocating your monthly contributions across a variety of different kinds of funds. We would recommend spreading your investments across 4-5 different funds, each of which will have invested in hundreds or thousands of different company stocks. You should invest some in aggressive growth funds, some in growth-and-income funds, some in blue-chip funds and some in international funds. Work with your investment adviser to determine the exact balance of funds that’s best for you.
As you move along in life, diversification in your investments may also mean bringing other investment vehicles into your portfolio. Stocks are the workhorses of younger investors, but older folks may prefer the security offered by the bond market. You can also diversify by looking for opportunities beyond Wall Street. Real estate can be a great way to invest, if you can buy homes with cash and then rent them out. Later in life, you should also have strong positions in cash. And once you finish paying off your mortgage, your home becomes a significant part of your portfolio as well.
We hope that you’ll follow this advice and spend some time crafting a diverse portfolio of investments. After all, thousands of years worth of investing wisdom can’t be wrong.
Photo by Kate Ter Haar. Used under Creative Commons License.