Diversification. It’s one of those words that you hear thrown around by financial types, but too often no one slows down enough to explain exactly what it means.
Diversification is a risk reduction tool. What do I mean by that?
By their very nature, investments are risky. The value of any single investment can go down dramatically due to any number of circumstances. But when you spread that risk around by having different kinds of investments, your risk of losing money over the long term is greatly reduced. Not eliminated, but reduced.
I recommend you diversify your investments (or assets) themselves and the types of accounts that contain those diversified investments.
This week, let’s look at the diversification of your assets.
Different types of assets tend to move up or down in different cycles. Blending the assets (and therefore the cycles) together can smooth out the ups and downs of your overall investment portfolio. The term “asset allocation” refers to a strategic proportional positioning of one’s investment assets over a number of investment types or classes.
Well that sounded boring. So, think of a recipe that calls for a variety of ingredients in varying proportions. The cook knows what those ingredients are. Everyone else just says, “Save me a piece!”
Stocks, bonds and cash are the most commonly used asset classes (a.k.a., ingredients).
So what is a stock? It is a security that represents ownership in a company. By owning a stock, you participate in the increase (or decrease) in value of the company as it is traded in the public market.
And what is a bond? It is a security that represents your having loaned a company, a government or a municipality a specific sum of money for a specific period of time. In return for the use of your money, the borrower pays you a stated rate of interest for the duration of the bond. At the end of the duration, your bond is redeemed and you get your money back.
Designing and constructing a portfolio of various asset classes appropriate for you and your specific circumstances is only the first step.
Since both investment markets and investor circumstances constantly change, the practice of portfolio rebalancing is important. Asset classes will rise and fall at different times and in differing proportions. By regularly “re-balancing” to your original asset allocation, you avoid over concentration in areas that have recently outperformed and maintain the original balance of your portfolio.
Next week, let’s tackle the less-often discussed topic of diversifying the tax treatment of your investments.
