The Importance of Investment Diversification

Everyone has heard the following statement: “Do not put all of your eggs in one basket.” If are saving or trying to preserve your wealth, then it is important that you heed this advice. Otherwise, you might be gambling by investing most, or if not all of your money into one type of investment.

Most people plan to save for retirement. But, this is not the only financial goal that most of us possess. In many households, individuals save for a new home or car, the birth of a child, or for the present or future costs of a college education.

It sounds easy to accomplish these goals. Fortunately, if you learn to manage your debt, make wise credit decisions and increase your savings, then your financial outlook can look brighter. If not, you might not reach your goals on time. Therefore, you should realize that financial planning can be a cumbersome job, and in some cases, you might even consider the aid of a financial professional. However, in the end, you will be held responsible for your financial decisions.

The market is unpredictable. While we can look at historical data, “past results” should not used to predict the future. At times, stocks will perform better than bonds and vice versa. You can even break down each of the investment options further. In some years, small cap stocks will perform better than large cap stocks; in other years, large cap stocks will produce better results. In some years, long term bonds will outperform short-term and intermediate bonds; however, it depends on the upward or downward movement of interest rates.

Thus, it is important that you spread your risk among several classes of investments (e.g. small cap, large cap, mid-cap, income, balanced, sector or international). In general, most financial advisors will tell you to use mutual funds to accomplish this goal. Keep in mind, it is not uncommon for a fund manager to possess 100 different stocks or bonds within a stock mutual fund or bond mutual fund. It is easier for an individual investor to achieve diversification through this method, when you have only $10,000 to invest, because many mutual funds only require a minimum deposit of $500 to $2,000 to participate.

Do not underestimate the power of diversification. In down markets, it can help prevent a lower return on your investments. Unfortunately, in an up market, it may limit your growth potential to the upside. However, if you are looking for growth potential, it is not uncommon for an individual stock to produce results worse than the overall market for several years, or in some cases, the company may file for bankruptcy, which would likely render your investment to be worthless. Consequently, the purchase of mutual funds are key financial instruments for many investors to achieve diversification. Otherwise, the portfolio might be more riskier than expected.