Ever hear the saying, “Don’t put all your eggs in one basket?” Just like eggs, your money is fragile. If the basket drops or breaks, you’re out of luck. That is why you need diversification. Essentially, diversification means spreading your money (eggs) into more than one investment (basket). This way, if one of your investments loses money, at least you have other investments.
What “baskets” can you choose from? First, you need to decide on a type of investment for each basket. The types of investments can be exhausting and some types even offer derivatives, so let’s just keep it high-level: cash, stocks, bonds, real estate. We previously covered these types of investments in the lesson on Compound Interest. So many choices! With diversification, you don’t have to choose just one, in fact, you should spread your money across them all.
“Baskets” are not to be confused with accounts. You can have one account with many investments inside. For example, your retirement account may have a blend of stocks, bonds, and other investments.
There’s more to diversification than deciding what type of investment to place your money in. Diversification extends to the sector you’re investing in as well. Let’s use stocks, which carry a lot of variety. You could invest in telecommunications, medicine, entertainment, finance, and the list goes on. So instead of choosing just one sector, invest your money in different sectors to allow for the best outcome if one or more of your sectors hits a rough patch.
If you are an employee of a publicly traded company on the stock market, your company might give the option to purchase company stock at a discount or they may offer company stock as one of the choices for investing within the 401(k) plan or you can simply choose to invest in the stock in your own brokerage account. It’s tempting because it’s an easy choice. Be very careful when choosing to put money into company stock. While it’s fine to invest in the company you work for, after all it’s a show of pride and support for your work, you don’t want to place a lot of “stock” in one place (couldn’t help the pun!). Think of it this way. What if the company takes a tumble on the stock market and as a result, lays off a bunch of employees, including you? Now you’ve lost both your salary and savings, if you invested your savings in company stock. So again, while it’s ok to invest in your company, limit your investments there, and remember to diversify!
Diversification is a timeless strategy that you can use for investing, but it becomes particularly useful when markets are taking a dip. That is because you may see a lot of your investments lose money, but if you diversify, some investments may trend the other direction, up. It’s important to diversify your investments across as many possible areas, so that you can brave the roller coaster of investing like a pro!
Homework: Choose 3 stocks from different sectors to follow over the course of one week. How did they perform compared to each other? If they all lost money, expand your stock selection to 10 stocks the following week. Was there one sector that did better than the others?