"Diversification is an Important Way to Avoid Losing Money"
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What is Diversification
Diversification is a way to spread your investing risk, whether you're investing for income or for capital gains.
If you go to race tracks, I know an easy system that guarantees you will always choose the winner of every race -- bet on every horse in the race!
Now, at the race track that system will make you lose money, because you won't win enough money to pay for your losing bets. The race track takes their share, to stay in business. And that's why betting on horses is a poor way to invest your money unless you're super good both at picking race winners and understanding the odds.
However, in financial investments the line between winners and losers is not so obvious, and that's good.
Just because one company is a winner, doesn't make other companies losers. If they're all making money, then the stock prices of all of them can go higher.
And you can make money by betting on all of them.
Say you're convinced the biotech sector is about to boom and you find five companies that look good.
You can buy shares in all five. Or pick the one you think will do the best.
It's true that if you pick the one that will do the best and you're right, you'll make the most money.
But what if that one company is the one where the chief research scientist dies of a heart attack or is closed down by the FDA? You've lost all your money
Spread Your Investment Risk
You just cannot know the future of your investments.
So it's much smarter to put some money on all five of those biotech companies.
That way, if one fails, but the other four make money, you'll probably still make money. That's some diversification of investments. Even better is to spread your money out among many types of industries.
Diversification applies to many types of investments. You should never place all your money in any one investment unless you're just starting out and you have only a little money anyway.
If you spread your buying out among stocks, that's stock market diversification. You can also include diversifying with bonds, mutual funds and market and financial of all kinds.
Ideally, you'd have your money invested in every part of the economy of the entire world. Your overall worth would go up proportionately to the growth of the economic well being of humanity. You'd profit from cotton in Bangladesh, copper in Chile, and software in Redmond.
You'd be average, not above average, but it's important to remember that most investors don't even get to that "average." They lose money, or fall far behind the overall markets. That's because they don't diversify, or not enough.
They try to anticipate what investments will become winners. They buy gold when everybody else is, and hold on after everybody else has started selling. They buy stocks when they're fashionable, and real estate when it's hot.
Because they're always following fads, they never get in on the bottom of any market, so they always pay too much. And because the tops happen soon after they enter the market, long before they've gotten as rich as they expected to, they don't sell at the top. They don't sell until it's clear that the market is going to be down for a long time. Therefore, they often lose money.
They buy and sell too late. They're always a step behind the "smart money." They wait until they hear about a trend on cable TV or read about it in a newsletter from a guru. Or until they talk to their neighbor at a cocktail party.
Diversification Does Limit Your Upside
Again, it's important to understand that diversification strategies are a "lose less" -- not a "win more." It's a strategy for safety.
The only way to win a lot consistently is to always be jumping on the next big hot market, before other people know about it. But what makes you so smart? You have to know how to predict the future. Even hedge fund managers don't always figure out the next big thing. And they're paid to follow markets and the economy on a full time basis. The rest of us don't have that luxury.
Markowitz diversification is intended to keep us from losing all our portfolio at any one time -- because all financial investments have some volatility.
However, many investments do not correlate in their performance. That is, when stocks are in a bull market, bonds may be down. Houses in Los Angeles may be booming in price while the market is dead in Houston Texas. While the French stock market is booming, China's is going down. While orange juice commodity prices are going up, cattles futures are down.
There is growing evidence that markets are becoming more correlated, perhaps because globalization is linking them much more. Perhaps it's because of the growing ability of capital to move from one thing to another quickly.
The financial crisis illustrated that well. Real estate crashed, bonds crashed, money market accounts were threatened, the stock market went down the most since the Great Depression -- and all this happened not just in the United States, but throughout the world.
It was sort of a "perfect storm" of financial collapse. Once the world's economies slowed down, the price of oil collapsed, and so did many other commodities.
The US dollar went down a lot, but now the euro is threatened.
In times like this, investors really wonder where is a safe haven, because there appears to be none.
In a way they're right. Everything did go down. The point though is that when you own as many different sectors of the economy as possible, you'll survive.
This is not a promise your portfolio will never go down -- in fact, it's almost a guarantee it will go down. However, it will not go down as much as somebody who has put all their money into one type of investment and then seen that crash.
You don't risk all your money on one type of investment. You spread your risk as much as possible. Therefore, when one investment goes down, others go up while others remain still.
People who put all their money into -- for example -- stocks, just before a bull market do make more money than someone who hedges their portfolio with bonds and money market funds -- but then they lose a lot more in a bear market crash.
Diversification is the most important way of protecting your retirement portfolio.
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