If your mom ever told you, “Don’t put all your eggs in one basket,” she provided you with the most important principle of investing you’re ever likely to get.
Diversified investment means that you should never weigh too heavily any one investment, or even one sector, in your investment portfolio in order to avoid overexposure. In mom-speak, portfolio diversification might also be expressed as, “don’t get caught with your pants down.” Putting all of your money into the Russian stock market, or cattle futures, or the snazziest new tech IPO just isn’t smart. Sure, there’s a chance it will outperform all other investments and you’ll be able to buy an apartment next to Beyoncé and Jay-Z. But there’s a greater risk that it won’t (and a real risk that it’ll tank altogether).
Is this a chance you’re willing to take with your money? The advantage of spreading your investments around is simple: You’ll be invested in enough sectors to be able to take advantage of positive trends without being wiped out by negative ones. Where and how you practice portfolio diversification is called “asset allocation.” When you’re building your portfolio, you’ll have almost infinite choices about where to put your money. Equities (a.k.a. stocks), bonds, small and large companies — all of those investments behave differently. Equities tend to have a higher risk but also a higher reward. Bonds, on the other hand, tend to increase in value more slowly over time but also suffer fewer big losses. When building a portfolio, you should consider how much risk you want to take on and then spread your money around according to that risk tolerance. People who won’t need their money for decades can afford to ride the ups and downs of a more aggressive, equities-heavy portfolio. Others who need their money for retirement within a few years might consider a more conservative, bond-centric portfolio. The easiest way to fully embrace a philosophy of portfolio diversification is by investing in market-hugging ETFs. One ETF might hold hundreds of individual stocks. That should provide plenty of eggs for your basket.