Feb 8, 2017
Diversification: How To Choose Investments When You Can’t Predict The Future
By Erica Bentley
Putting your money in a variety of investments that aren’t subject to the same risks? That’s diversification.
Let’s see if you’ve heard this line before. “Don’t put all your eggs in one basket.” You may not know it, but its about diversification.
It’s probably one of the most common investing phrases out there. Back in the 17th century, people said it like this: “Don’t trust all your goods to one ship.”
These expressions might be common, but they don’t mean much to many of us. Why? Because most of us are not egg-basket carrying, merchant-goods-shipping people.
‘The One About Diversification?’
Let’s take an example from Monica and Phoebe in “Friends.” In the episode The One With Phoebe’s Cookies, Monica laments the loss of Phoebe’s grandmother’s cookie recipe in an apartment fire.
Monica: Why didn’t you make a copy and keep it in a fireproof box and keep it at least a hundred yards from the original?
Phoebe: Because I’m normal.
Monica is getting at the heart of all of these important investing phrases. If important things are stored together in the same place, they risk the same fate.
The egg basket could drop. The merchant ship could get attacked by pirates. And the chocolate chip cookie recipe could meet an unexpected demise in an apartment fire.
So what’s an investor like you to do with your important things? Yes, we’re talking about your money. When you’re not sure what the future will bring, you shouldn’t concentrate your risk in any one place, asset, or investment.
Instead, you can diversify.
Put your money in a variety of different investments that are not subject to the same risks and therefore are less likely to share the same fate. Nobody can foresee the future. It’s impossible to know what will happen tomorrow in the geopolitical landscape or what fate will befall a certain company or industry.
Important to know: Diversification does not eliminate risk altogether.
We don’t know how businesses will perform or how consumers will react. And we can’t predict how one country’s economy will grow or slow in the coming decades.
A couple things about diversification to know:
Diversification means spreading your risk around.
It means making multiple investments, so your portfolio’s performance is not tied to a single asset class, industry, company, or region. A well-diversified portfolio has exposure to a variety of different industries, companies, geographical areas, and asset classes.
Diversification helps you make short-term decisions without knowing the future.
At its core, diversification is an important part of any long-term investing strategy. Say you’re interested in investing in large American companies because you believe the American economy has long-term growth potential. Without knowing how changes in government policy may create or restrict business opportunity, it’s hard to know which company will perform best.
Without knowing how consumer behavior may change or advancements in technology may impact industries, it’s hard to know which sector will perform best.
That makes it difficult for the average investor to pick just one for their investment portfolio. But you don’t need to pick just one American company or industry. You can diversify. If you have broad-based belief that the American economy will continue to grow, you can invest a little bit in a bunch of large American companies across various industries. This is just one example of diversification.
Diversification doesn’t protect you from bad days, months, or even years.
Important to know: Diversification does not eliminate risk altogether. There is the possibility that global markets take a hit (think: the sub-prime mortgage crisis of 2008 that contributed to the Great Recession). Global markets dropped almost in lock-step. You can’t diversify your way out of something that has a blanket effect on the entire market.
You can start to diversify right now.
Diversification is a strategy that you continuously use to decide how to invest your money. You can use it today, and you can use it next week. If you knew the future, you wouldn’t need to diversify. You’d just pick the winning sectors and companies and be done with it.
However, since you don’t, diversification can help you choose how to invest your money.
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