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Investment Diversification: The Basics

Sep 15, 2016 | 3 min read

 

Diversification is something financial experts and advisors bring up constantly when evaluating retirement portfolios. Yet for many investors, it’s a term that is vague at best. You’re not alone if you don’t quite know what it means or understand why you should care about it. Among financial pros, the term can have several definitions and explanations, which complicates things even more.

That said, diversification remains an extremely important aspect of retirement strategy and most – if not all – other investment channels. That’s why retirement plans provide lots of pretty charts showing it, and encourage you to manage for it.

So what does it mean and why does it matter?

 

What it means to diversify

Imagine you have an apple tree. This tree provides all your food. But if you harvest apples in the fall, what are you going to eat in the spring or summer? Planting some corn might be the answer. Buying a meat source that isn’t susceptible to the seasons is another way to ensure you have food, no matter what happens to the apples.

The same idea works for investing. If your retirement investments are heavily in U.S. stocks, including shares in large, small and medium-sized companies, it might also be a good idea to have some exposure to international markets. You might also buy bonds, or even commodity funds that track the price of gold, silver, copper or energy. This spreads out your assets; they’re diversely allocated, placing the aptly named end goal of “diversification” within your reach.

The idea behind diversification is that, if one section of your portfolio struggles, the other parts may help protect or even grow your overall investment. This reduces the risk you take on, and helps ensure you can continue eating through all four seasons…so to speak.

 

Cut through the diversification confusion

This easy-to-understand concept gets muddled. First, it isn’t entirely clear what constitutes a “diversified portfolio”. Some studies have found a pool of 20 stocks is nearly as diversified as a pool of 150 or more stocks. Within those stocks, some might be higher risk and others lower risk. An investment portfolio could include only stocks and bonds; alternately, it could be filled with other types of investment vehicles, such as real estate, commodities or even fine artwork.

 

Some quick ways to diversify your savings

When establishing your 401(k) or other workplace retirement savings plan, you might have been asked if you want your contributions to go into a target-date fund or a lifestyle fund. Target date funds will diversify your portfolio based on when you expect to retire and will change the asset allocation as you age, generally reducing exposure to riskier investments – such as stocks – as you near retirement. Lifestyle funds will diversify your investments based on other factors such as your risk profile, or when you need access to your money. Tools like these can help ensure your portfolio remains diversified without you ever lifting a finger.

If you instead selected a few different investment options on your own, you’ll want to periodically check your allocation to make sure that the results in the market don’t impact your diversification over time. When investing in funds with specific purposes, you’ll receive the benefit of diversification in the specific area you’re investing – like a wide array of international stocks in an international fund, or a large number of U.S. companies in a large-cap U.S. index fund. But you might also want to avoid placing 100% of your savings in just one fund, as this gives you the rewards – and risks – of that track alone.

 

Bottom Line

Investing involves risks and some investments have more risk than others. Diversification does not assure a profit or protect against a loss in declining markets; and it can seem overwhelming because of all the complex options investment firms offer. But you can keep your retirement and other investment strategies simple – by investing in a target-date or lifestyle fund, for instance – and still have all the diversification you are likely to need.

For more information about how to diversify, check out our article Financial Diversification: The Strategy.

 

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