“The beauty of diversification is it’s about as close as you can get to a free lunch in investing.” – Barry Ritholtz
Don’t put all your eggs in one basket. We’ve all heard this at least once in our lives, but in personal finance, it’s more commonly referred to as diversification (of your investments). Diversification helps to manage risk in your investment portfolio. By spreading your money across different asset classes (stocks, bonds, cash, and property), you can manage the volatility (ups and downs) of each class.
Economic theory posits that asset classes don’t always rise and fall at the same time. For example, if you invested in a bond fund that lost 5% of its value one year (i.e., you lost some of the money you originally invested), had you only invested in this bond fund, you would have made a 5% loss. If you had, at the same time, invested 50% of your money into this bond fund this year and invested 50% into a stock fund that generated a 10% return, then you would have made a 5% return on your portfolio for that year.
Creating a Diversified Investment Portfolio
How much do you need to invest in each asset class to be considered diversified? There isn’t a one-size-fits-all asset allocation strategy for diversification, but generally people argue that if you are saving for retirement, your portfolio should be made up of your age as a percentage in bonds and the remainder in stocks. As you get older, you increase the holdings of bonds to stay aligned with this rule. For example, if you’re 20 when you start investing for retirement, you invest 20% of your money (the money set aside for investing, not necessarily all of your money) into bonds and invest 80% of your money in stocks. When you turn 25, you make sure that your bonds are 25% of your portfolio and your stock holding is 75%. This is called rebalancing. You can rebalance by either selling some of your investments in an asset class that has performed well or buying more investments that are not doing well. You can also do a combination of buying and selling to rebalance your portfolio.
What’s the simplest way to have a diversified portfolio? Index funds. An index or tracker fund is similar to a mutual fund (which may hold a basket of stocks). Instead of using a basket of stocks picked by a fund manager, an index fund holds the same stocks as you’d find in a market index. For example, if you invested in a fund that tracks the FTSE All-Share index, your fund would buy a part of more than 1000 companies traded on the stock exchange.
Take the example of a nine-to-five job and your income. Your job may be your main source of income. If you are suddenly made redundant, you may struggle to support your lifestyle. If you are suddenly made redundant but have other sources of income to rely on, you may be able to keep supporting your lifestyle. By diversifying your sources of income (that is, not just relying on income from your employer), you can radically reduce the impact of a sudden loss of one of those sources of income.
In summary, investing in more than one asset class can reduce the impact of a major loss in value of any class.
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