If variety is the spice of life, diversification is the
heart and soul of investing.
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Investment performance tends to move in recognizable patterns, though
not on a predictable schedule. In any period of time, while some of your investments
are living up to expectations, others may be providing disappointing returns. If
you want your portfolio, or combined group of investment holdings, to provide the
best possible return while also limiting the risk of major losses, you have to diversify,
or spread your principal
among different investments within the asset classes, such as stocks,
bonds, and cash, you've selected.
That's because any time all of your money is concentrated in one or two investments,
your financial security depends entirely on the strength of those investments. And
no matter how sound an investment may be, there will be times when its market price
falls, or it yields less than the rate of
inflation, or both.
For example, if your life savings are in
certificates of deposits (CDs) paying 3%, while inflation is also around
3%, you're facing a loss of buying power. Or if you own hundreds of shares in
a company that loses money, cuts its dividend, and drops in value in the stock market,
you'll be short dividend
income and perhaps part of your original investment if you sell your shares.
THE FIRST STEPS Diversifying your
investment portfolio is no easy matter. For starters, you need enough money to make
a variety of investments. And, you have to judge each individual investment not
only on its own merits, but in relation to the rest of your portfolio.
If you put some of your long-term investment money into
fixed-income investments like corporate or
municipal bonds, you may also want to make
equity investments like individual stocks, stock
mutual funds, or stock
separate accounts. If some of your short-term investments
are CDs, you may want to put the rest in money market funds or US Treasury bills.
THE SECOND STAGE
Diversification also means spreading your investment dollar
within a specific type of investment. For example, your stock portfolio is not diversified
if you own shares in just one or two companies, or in companies all involved in
the same sector of the economy, like healthcare or utility companies. Nor are your
fixed-income
investments diversified if you own only municipal bonds issued
by the state in which you live. If you invest in five
mutual funds, but they all track small growth companies,
you're not diversified either.
Many financial advisers suggest that real diversification also calls for international
investments. Because world economies respond primarily to what's happening in
their own countries or regions, putting money into overseas markets is a good way
to balance what's happening at home and take advantage of the growth potential
in those markets.
One of the most convenient ways to invest in overseas markets is
to buy
American Depository Receipts (ADRs), stock in overseas companies listed directly
on US exchanges, stock in US companies with major international markets, or international
mutual funds,
exchange traded funds (ETFs) or
separate account funds. Remember, though, that currency
fluctuations and potential political or civil unrest could affect the value of your
international investments.
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THE VALUE OF FUNDS One of the
reasons mutual funds and
variable annuities keep cropping up in discussions of diversification
is that they are internally diversified. Each fund or account may own dozens or
more different stocks, bonds, or whatever it specializes in. That way, if some of
the holdings aren't performing well, they may be offset by others that are doing
better. In fact, balanced funds include both stocks and bonds to provide diversification
in different categories of investments as well as within each of those categories.
Because mutual funds
and variable annuities pools investors' money to make their purchases, they
can generally achieve a breadth of diversification that no individual can. However,
you do pay annual asset-based fees on these investments, which you don't on
individual securities.
You might also consider
exchange traded funds (ETFs), which allow you to buy shares of a portfolio
of stocks - each ETF typically linked to a specific market
index. ETFs trade like stocks, and you buy them through
a brokerage account.
ONE MORE THING TO REMEMBERDiversification
is essential for retirement investments. It's especially important if a stock
purchase plan is part of your
pension plan, because your long-term payout will depend on how
well your employer's stock does. You'll want to balance your dependence
on the company's financial health with different investments in your own accounts,
including your 401(k)
or similar plan.
Diversification is especially important if your employer's stock is
cyclical, which means its price is strongly influenced by changing economic
conditions. Hotel stocks, for example, tend to be depressed in a slow economy because
people travel less. If that's the case, you may not want to put too much money
into other stocks that behave the same way.
To extend the idea one step further, you may want to think twice about building
a portfolio full of stocks and bonds in companies that are in the same business
your employer is in. If the pharmaceutical business declines, for example, and all
you own are drug company stocks, you'll really need an aspirin.
DIVERSIFICATION FOR THE LONG HAUL
Diversification isn't the same as buying randomly. If anything, it's the
opposite, because it means buying according to your strategic plan to get the right
mix of investments. But there's nothing wrong with achieving diversification
gradually. If you decide to expand your large company holdings because that part
of the stock market seems poised for steady growth, you can do it and think about
adding to your small-company portfolio in the months ahead. The right level of diversification
for you at a given time depends on a variety of factors, including where you are
financially, what your goals are, and what the market is doing.
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