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The Importance of Diversification

You've heard the term "diversification"?

Usually, in a Wall Street context, you might hear disparate versions of diversification, but they all mean the same thing -- to not let one stock or mutual fund or other single investment kill your portfolio.

To diversify means to “spread it around” or “not put all your eggs in one basket.” When we vote, we look at several candidates and select one for better or worse. In the world of investing, there are several investment vehicles available, but unlike voting, you need not choose only one. Among the reasons why mutual funds are so popular these days is that they select several stocks, bonds, or other investment vehicles for you. Funds are managed by professional money managers who choose a variety of investment vehicles. In short, they diversify.

Owning a mutual fund does not mean you cannot also own stocks, bonds, or more than one fund. Tantamount to putting money on seven numbers on the roulette table instead of just one, you have better odds at winning. However, unlike the roulette wheel, which will have just one winning number per spin, you could win on several stocks.

The most prominent strategy is to mix high- and low-risk investment vehicles and to allocate the assets wisely, as cited in the examples in the previous risk/tolerance section. Once your funds are allocated into different asset groups, you diversify within that asset group. Buying stock means buying stocks, giving you a better chance at winners within that asset class. One investor who allocated a portion of his portfolio into mutual funds learned about diversifying just in time. Heavily into global funds in the early 1990s, the investor took the suggestion to branch out a little and try some new funds, including those in the areas of health and technology. Sure enough, his global funds took a downturn in the late 90s, his health fund brought him good returns, and his tech fund brought him excellent returns. Whereas this is also a story of allocating assets, it is a story of diversifying. Spread it around. That way, if one egg falls out of the basket, you still have enough left to make an award-winning omelet.

The key lesson here is that one of the biggest mistakes an investor can make is putting everything in one pot. If the pot boils over, or capsizes, guess who gets burnt?

Published Aug 03 2006, 07:17 PM by moneycoach
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