Howdy Wall St. Willy! In the newspaper I read about diversification, but what is diversification anyway?
Why would I need diversification?
You need diversification to reduce the risk of losing money or getting negative returns
Well, who needs to diversify?
All investors need to diversify. Remember the old saying, “Don’t put all your eggs in one basket”?
If I want to diversify, what factors should I consider?
Another factor to consider is geography. You should divide your investments among US, developed markets – US, Europe, Australia etc., and emerging markets – China, India, Brazil etc.
Once more factor to consider is tax. Whenever possible, you should try to make tax-advantaged investments with pre-tax money like a 401k or with post-tax money like a Roth IRA. You can also make non-tax-advantaged investments like your regular brokerage account.
One more factor that you should consider is liquidity. You should spread your investments between liquid assets like cash or money market securities and not-so-liquid assets like CDs or certificates of deposit and real estate.
But, when we say diversification, the most important factor is investing in different asset classes.
Well, why do I need to diversify across asset classes?
You need to diversify across different asset classes because things within an asset class generally show very similar risks and returns but different asset classes have different risks and returns.
When you invest your money in different asset classes, even if one asset class does not perform well, another asset class is likely to make up for the loss. This means that over time, your overall return would fluctuate less and will be more predictable.
Can you give me an example of that happening?
Sure. If you have $1000 to invest, you can invest 75% or $750 in stocks and 25% or $250 in fixed income. This way, if stocks perform well, the bulk of your portfolio gives a great return. But, if stocks do not perform too well, you still get a predictable return from your fixed income investment.
Well, is this proportion of 75% and 25% the same for everyone of all ages?
No. I will cover that in detail when we talk about asset allocation. But that’s a topic for another time.
Thank you very much for telling me about diversification, Wall St. Willy.
You are welcome, Sooper Cooper. Remember, Finance is Your Friend!