The timeless adage, "Don't put all your eggs in one basket," applies to investors as well as poultry farmers. Diversification of assets involves spreading your investments both between and within three primary categories: cash equivalents, stocks and bonds. Although diversification is a commonly used investment strategy, it also has its disadvantages and risks.
Without guidance, amateur investors may run the risk of over-complicating the diversification process, as noted by Money Magazine senior editor Walter Updegrave in a 2009 CNN Money article. An overly diversified portfolio is hard to maintain and rebalance on a regular basis, which in turn makes it less effective and low-risk. To avoid this pitfall, the U.S. Securities and Exchange Commission recommends investing in mutual funds instead of individual asset investments. Mutual funds take money from several investors and invest it in a variety of stocks and bonds to maximize investment and minimize risk.
On the other side of the spectrum, some investors may not diversify their portfolios enough to make a significant difference. As noted by the Securities and Exchange Commission, the best way to diversify is to do so both within and between asset categories. Not only should investors invest in stocks, bonds and cash equivalents, but they should also diversify within these categories. Within the category of stocks, for example, investors may select both small- and large-company stocks to further diversify their portfolio. State Farm Bank notes that some mutual funds may include the same stocks, so be sure that you learn which specific stocks are included in funds before you invest.
A Step Further
For experienced investors, asset diversification may be an inadequate approach. Diversification of assets involves spreading your assets over a variety of classes with similar securities. Asset allocation is a riskier, more aggressive strategy that entails investing in a variety of classes with different risks. For example, you might invest in a few high-risk stocks as well as low-risk government or corporate stocks. Although this approach is risky for amateurs, it provides security in unpredictable market conditions, notes State Farm Bank.
Diversification of assets may not be the ideal strategy for some situations. For example, as noted by the Securities and Exchange Commission, diversification may be inappropriate for a family that is saving up for a summer vacation or other short-term expense. However, investors whose savings will be used for long-term goals, including retirement plans and college, are better off including some risk in their investment portfolios. In these situations, asset diversification is likely to result in higher returns and fewer losses.
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