Diversification is a fundamental aspect of financial planning. In a nutshell it is the old adage to not put all your eggs in one basket. If you have all your eggs in one basket and something happens to the basket then you are in big trouble. But instead, let’s say you keep some of your eggs in the refrigerator. Then if something happens to the eggs in the basket you still have the ones in the refrigerator.
Of course in financial matters we are not dealing with eggs. Instead we are dealing with money. And to be specific, with money we are dealing with investments in particular. Investments come in three basic types: Stocks, Bonds and Mutual Funds. Basically the principal of diversification says that you should have a little in each of these to diversify yourself against risk of the stock market and whatever else might happen in life. Let’s review each of these asset classes and discuss the risks.
Stocks are the first type of investment. They are the most aggressive and hence the most risky. They are risky because there is nothing that says the company you own the stock of has to pay you and in fact the price of that stock may go down causing you to lose value. Thus in a stock you assume all of the risk and the company assumes none. If the company was to go bankrupt you are just up the proverbial creek. We will see how this differs from bonds in a moment. But all that aside, stocks are the best way to earn a good return over the long-term on your money. The fact is most companies do not go bankrupt and that in fact most stocks, on average, have increased in value over the long-term. Thus it is a risky investment but one that provides a good return.
The next class of investment is a bond. A bond differs from a stock in that it is a debenture or a debt owed to you. You are essentially providing the company that owns the bond with money, which they can use. In return they agree to pay you back at a specified interest rate. This investment is therefore somewhat protected if the company goes bankrupt because the debt follows them into bankruptcy. Therefore we can see why bonds are overall normally safer than stocks from the same company. However because of this safety their return is not as great.
The next class of investment is the Mutual Fund. Think of a mutual fund as a whole group of stocks and bonds all lumped in together. A better illustration might be to think of the way birds flock together. One stock or one bond is an individual bird but in a mutual fund they are in a flock managed by someone else. Who decides which stock or bonds go into the flock? Basically a professional fund manager makes these decisions based upon his or her own analysis of the market and the underlying fundamentals of the individual securities. You basically give him your money and trust that he or she does a good job. The risk of any particular fund is based upon the criteria used to choose the underlying securities. There are wide ranges of mutual funds from the high-risk foreign security funds all the way down to the Government bond fund, which is almost as safe as the bonds themselves. Needless to say, you pay the mutual fund manager for making these investments and that is something that deserves a topic of its own. For now just remember to always look at the “load” on the fund. The load is investment terminology for the fee you pay the manager.
As an investor you should consider each of these categories to diversify against risk. If you follow a diversified investment plan you reduce your overall risk as compared to being invested in only one type of security. However, diversification is only one part of an investment strategy though it is an important part. Therefore, you need to also take into consideration other factors such as the time frame in which you can leave the money invested and your own personal comfort level with risk and market fluctuation.
Information is for educational and informational purposes only and is not be interpreted as financial advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.