What Is Diversification?

22
September

It has always been dangerous to put all of one’s hopes in a single place, hence the saying, “don’t put all your eggs in one basket.” The truth of this principle is perhaps nowhere more evident than in savings and investing. Limiting all of one’s savings to a single savings account or CD, for example, might be safe, but such a plan will not allow deposits to grow sufficiently over time and keep up with inflation. When it comes to the stock market, putting everything in one sector, one stock, or one mutual fund is extremely risky. If all of one’s money is in a single investment, all of it will be lost should that investment tank. Unfortunately, this is what happened for many people during the tech stock crash at the turn of the twenty-first century. Persons who had too much in the technology sector lost most of their life savings when the bottom fell out of that part of the market.

Diversification is the only way to minimize potential savings and investment losses and increase the odds of earning a good return on deposits over time. Simply put, diversification is the spreading of monies across several different accounts and investments in order to lower the risk of loss and increase the chance of a substantial return. When monies are spread across many different kinds of investment and saving vehicles, gains in one or more area can help offset losses in another. Wise diversification of funds not only offsets losses to produce a net gain and loss of zero, it also helps guarantee that gains far outpace losses so that at the end of the day, there has been a net gain in the bottom line.

Even though diversification is easy enough to conceptualize, it is not always easy to achieve true diversification in one’s portfolio of savings and investments. Some people think they are diversifying their investments if they purchase stocks in a variety of companies. However, if all these companies belong to the same sector of the economy, then true diversification has not been achieved. For instance, an individual investor might own stock in several different banks, but this is not true diversification, as all the money is invested in one sector — financials. Should the investor invest some money in a few banks, some in a health insurance company or two, and some more in a company that produces food products, then the investor has achieved a certain level of diversification in the stock market. In this case, several different sectors are represented in the same portfolio — financials, healthcare, and consumer staples.

The best way to diversify one’s investments is through a combination of investing across different sectors, investing in companies of varying sizes, and saving money in a variety of traditional savings accounts. In addition to investing in different sectors, it is also wise to invest in a variety of different-sized companies within each of these sectors. Choose some very large, multinational corporations and smaller, regional companies. The small companies often have excellent growth potential, while the larger firms usually have the benefits of fat dividends and a proven track record of success. Most investors should also not limit themselves simply to picking individual stocks but should also buy several different kinds of mutual or exchange traded funds. Since each of these funds is a collection of several different stocks, diversification is achieved almost immediately, especially if the fund has holdings in many different sectors.

Regarding traditional savings accounts, no diversified portfolio of savings and investments is complete without a common statement savings account, at least for an emergency fund. Money market funds that have a slightly better return with little to no risk are also an easy choice for those who want to diversify their portfolios. Certificates of deposits will usually offer an even higher interest rate, but only money that will not be needed for several years should be parked in these accounts. Treasury bonds are another savings possibility that should never be overlooked.

Successful savers and investors always point to diversification as one of the reasons for their good fortunes. Keep this overview in mind, and follow these tips to achieve greater financial peace of mind.

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

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