This is part three in a series of articles for beginner investors. The first two parts covered why you should invest, and types of investments. This article covers the importance of diversification in your investments.
My high school Biology class taught me that the health of a particular eco-system could be measured by the bio-diversity found there—meaning, if there were a lot of different species living in one place, you could bet that was an ecologically healthy environment.
Your financial health is similarly reflected by the diversity of your investments. It’s easy to see that putting all of your eggs in one basket is a recipe for disaster—just look at any recent financial scandal from Enron to Bernie Madoff and you’ll find someone who has lost everything because it was all placed in the same poorly managed (to say the least) basket. However, other than knowing better than to give your life savings to a Ponzi scheme or place it all in your mattress, how do you know how to diversify?
Why You Should Diversify your Investments
Here are some basics to keep in mind when trying to maintain your financial health:
Portfolio: It’s Not Just Another Word for Briefcase
You’ll often hear people refer to their investment portfolio. Basically, this is the breakdown of the different ways you invest your money in order to reach your goals. Your portfolio will change throughout your investing career as your goals change. When you first start investing, your portfolio will reflect the fact that you are able to take a long view and will include investments that may be more volatile. You have the time to wait out the market and allow your stocks to recover. If you are closer to retirement, you want to make sure your money stays put and possibly shows some modest growth. In that case, your portfolio will likely focus more on less risky (and lower returning) bonds.
In short, your risk tolerance and time frame help determine the diversity of your portfolio.
Determining your risk tolerance is an important part of drawing up your investment portfolio. For those investors who are willing to watch their money go up and down with the instability of the market, a more aggressive portfolio (but still one that incorporates diversity!) will give the possibility of higher returns, while still maintaining some stability. Those who don’t have the stomach for rapid declines can go the more conservative route but still incorporate a few riskier investments that could pay out higher returns. No matter what your risk tolerance is, however, it is imperative that you diversify your portfolio so that no one investment dominates. That allows both aggressive and risk-averse investors to enjoy stability and the potential for growth.
Beware of Sure Things
When it comes to investments, people will sometimes get dollar signs in their eyes and forget the most basic tenet of investing: diversify! If you ever come across a “can’t-fail” investment strategy, back away slowly. There is no such thing a sure thing. Accepting some risk means that you know everything is above-board. The only real way to mitigate the inherent risk of investing is to diversify. Any other scheme is just that—a scheme.
Next week, we’ll discuss how to find a financial advisor to put this all together.