Why Diversify?

29
December

Financial planners don’t see eye to eye on many things. But most of them agree on one piece of advice: Investors must diversify. They’ve seen the unpleasant results of not doing so. When it comes to protecting your hard-earned money, this is a tip you can’t afford to ignore. Regardless of how confident you feel about a particular stock, there are no sure bets.

Consider the plight of Susan, who was intensely loyal to a well-known oil company. Her father and grandfather both retired from this organization and had nothing but admiration for its management. Susan plowed every penny of her savings into buying stock in this company. She had full confidence her money would grow and flourish.

Imagine Susan’s surprise when a devastating oil spill caused the stock to plummet. The future of her entire life savings was thrown into uncertainty as a result.

You don’t have to learn this lesson the hard way. You must diversify.

What is diversification?

When someone offers the advice to diversify, they are basically saying “do not put all your eggs in one basket.” Loyalty is a great thing, but it is not admirable when you are putting yourself in a vulnerable financial position. Focusing all your funds in a specific asset type – stocks or rare coins, for example –results in an unbalanced portfolio that is more likely to topple over. Likewise, concentrating all your stocks in one industry leaves you exposed.

Why diversification matters

Just as Susan learned, no specific investment is foolproof. The erratic economy over the past few years has painfully illustrated that no investment is completely safe. We’ve seen industry giants knocked off their pedestals, slash or completely eliminate dividends, and experience drastic free-falls on their stock prices. If all your money is tied up in a single company that abruptly goes bankrupt – what then? Few people can afford to take this gamble.

A diversification plan

Now that you know the importance of diversification – exactly how do you go about achieving it? The following guidelines will help you focus your investments accurately to meet your personal financial goals:

Stocks for growth. Historically, stocks have provided the highest long-term returns. That’s the good news. The bad news is that along with these strong returns comes the greatest potential risk. Consider buying stock in diverse industries, such as healthcare, technology, and retail. This way, you will not be so directly impacted by a negative downturn or seasonal fluctuations in a particular market segment.

Cash for liquidity. Tying up all your money in investments that are not easily accessible is not smart. You need to be able to get your hands on cold hard cash quickly in the event of an emergency. Cash assets include T-Bills, money market funds and short-term certificates of deposit.

Bonds for income. Bonds have longer maturities and provide more stable income over time. They are much more stable than stocks. Most people need some bonds in their portfolio. Financial advisors recommend that your bond holdings gradually increase as you near retirement. The reason for this is simple—you need predictable and safe investments as your earnings years come to a close. You don’t have the time to recover from mistakes and setbacks.

Stack the odds in your favor

There is no guarantee of long-term success with any investment strategy. But a balanced portfolio improves your chances of earning higher returns with lower exposure.

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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