The old saying, “Don’t put all your eggs in one basket” can apply to many situations, but when it comes to money, it pretty much means only one thing: Diversify your investments. Whether you are very risk tolerant when it comes to investing or a stock market chicken, you should pay attention to diversification. Here’s some helpful information about diversification.
Two Levels of Diversification
There are two levels of diversification – asset class diversification and diversification within the asset classes. At the very least, all investors should consider asset class diversification. We can also refer to this as asset allocation. You “allocate” your money into different types of investments in order to reduce risk. The main asset classes are stocks, bonds, and cash.
Here’s the simple idea: Don’t put all your eggs in one basket, such as all into stocks or all into bonds, and you reduce your risk. Stocks, bonds, and cash all have risks, but the risks are different. Diversifying spreads out the types of risk you are taking, and subsequently reduces overall risk.
If you have a small portfolio of investments, you might be able to stop there. But as your nest egg grows, you might consider diversifying within the asset classes. What that means is that you invest in several different types of stocks, several different types of bonds, and possibly even different types of cash investments.
Wonder how diversification works in a portfolio? It boils down to a phenomenon known as correlation. Correlation refers to how the investments move relative to each other. Investments that typically move up together and down together (such as two different stocks) are positively correlated. Investments that typically move in opposite directions depending on market conditions (such as a stock and a bond) are considered to be negatively correlated. You can also have uncorrelated assets, but that’s a subject for later.
Stocks and bonds are the most commonly touted asset classes when discussing correlation and diversification. In general, when stocks are moving up, bonds tend to move down, and vice versa. But this is not always true. An excellent example of aberration of this idea happened in 2008. Most types of bonds went down, just like the stock market did that year. That event was unprecedented, and certainly doesn’t represent the typical investor experience.
The bottom line is this: If you can decrease correlation in your portfolio by choosing to own assets that don’t all move in lock-step, you decrease the risk – or volatility — of your portfolio. And that generally makes people pretty happy.
Whether or not you are a chicken when it comes to investing, spread those investment eggs into different baskets, and then don’t obsess over it. Find something else to do and don’t fret over daily, weekly, and monthly movements of your investments.
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