Using diversification to combat risk
Diversification — spreading your money among many different investments — attempts to take a middle road through the highs and lows of market performance, allowing your money the opportunity to grow regularly with fewer fluctuations along the way.
Choosing a mix of investments
What goes up usually comes down
The reason for diversification is simple: By including a variety of investments in your portfolio, your risk is less than if you put all your money in one type of investment.
All securities behave differently from one another, going up and down in separate cycles and to varying degrees. An individual stock is affected by a combination of different elements, including the overall stock market, health of the industry the company does business in, and the company's own performance. Though stocks generally vary more than fixed-income investments (such as bonds), fixed-income prices can be affected by changes in interest rates and the overall fixed-income market.
Because investments react differently to market conditions and other factors, you may want to keep a well-diversified portfolio in order to balance out the ups and downs. Though you are not as likely to achieve a substantially large return with a highly diversified portfolio, you are attempting to protect your savings from short-term losses and allowing them the opportunity to grow over time.
Diversification within and across asset classes
Diversification can be achieved in many ways, for example: within an asset class (such as stocks) or across asset classes (such as stocks and bonds). In the first case, you are likely to have smaller swings of value over time in a portfolio that holds stock in a dozen different companies instead of one. You are likely to have still smaller swings of value if you add fixed-income investments, such as bonds, to your stock portfolio.
Risk, or variability, of different markets can depend on national and international developments. Economic factors, such as production, employment, monetary policy, and levels of investment, influence markets for equities and fixed-income securities in different ways. How you diversify across asset classes, therefore, has a direct effect on the amount of risk, or variability of returns, you are likely to have.
Practicing diversification in your savings plan
Mutual funds that invest in both stocks and fixed-income investments (balanced funds) offer one way of diversifying both across and within asset classes.
Another way of diversifying is to choose your own mix of investments, rather than invest in a fund where the mix is determined by someone else. However, if you take this route, you need to be more diligent about evaluating your choices and may want to get assistance from a professional advisor.
Two simple rules
When diversifying your investments, remember to:
1. Reduce "security-specific risk."
Purchase a broad range of investments across various companies and industries rather than a limited selection of individual securities. This way, no single investment will dominate the performance of your retirement account.
2. Spread your money across the different asset classes: stocks and fixed-income.
Each asset class has its own unique risk and return attributes. And because the risks of one asset may complement the risks of another, it may be possible to achieve higher investment earnings and reduce your portfolio's volatility.