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Investing 101: The Importance of Diversification

Whenever you invest, you run the risk of loss. No matter the investment, there is a chance that you will lose your money. Part of building a successful investment portfolio includes managing the risk that comes from investing so as to limit your losses and enhance your gains as much as possible. One of the ways to do this is to build a portfolio that involves some diversification.

Diversification is the inclusion of investments with different characteristics. Your investments should balance each other out, and provide you with a well-rounded portfolio that is capable of recovering from market setbacks, and that sees its losses limited. Without diversification, your portfolio could be completely wiped out if one market crashes, or if an industry sustains prolonged losses. Diversification [3] is one tool in the arsenal that allows you to take calculated risks designed to help you build wealth through investing.

Diversification Across Asset Classes

One type of diversification to consider is in the area of asset classes. Asset classes are types of investments. These can include stocks, bonds, commodities, cash, currencies and real estate. You want to consider holding different asset classes, since some tend to move in response to different market forces. For example, when stocks are tanking, other asset classes might be doing better. Holding other types of assets can help limit the overall losses in your portfolio from a crashing stock market.

Asset class diversification can also help you achieve your goals for your investment portfolio. Some asset classes are known for their growth potential, and others are known for their safety. If you want a little more growth in your portfolio, you can add more commodities, currencies or stocks, and if you are hoping to add a little more safety, cash and bond investments might be helpful.

Other Types of Diversification

You should also consider other ways to diversify the holdings in your portfolio. Look at your holdings. Do you have too many companies that could be considered “travel” investments? If you are investing in airlines and in hotels, you might try diversifying to investments in other categories, since the same factors that affect airlines also often affect hotels. You might have too many domestic investments; it might make sense to add some foreign diversity so that if the domestic market crashes, you have your foreign holdings to cushion the fall.

It is also a good idea to consider whether or not an inordinate amount of your money is invested in one asset. Perhaps you are overweighted, with 70% of your portfolio in your company’s stock, through your 401k [4]. That is a recipe for disaster, since your company could go under — leaving you in big trouble.

Watch Out for Over-diversification

Diversification doesn’t necessarily mean that you have money in every possible asset class, and in every industry. The idea is to be prudent in your diversification, making sure that you have a portfolio with investments that complement each other. Too much diversification can weaken some of your positions, diluting your investments to the point where they are not as effective — and profitable — as they could be.

Think about your goals, and what sort of asset allocation might help you best reach them. Then, create an investing plan [5] that has enough diversity to help you limit some of your risks, but not so much that your portfolio is diluted into ineffectiveness.

(Photo: Phillip Taylor PT [6])