There’s nothing quite as beautiful as seeing a field of poppies while driving across California. As spectacular as the state flower might be, Californians know that the beauty of our roadways and backyards depends on a rich diversity of flowers.
Diversification is a key component in gardening—and in investing, too. Experienced gardeners say that gardens need to have a good mix of different kinds of plants, such as trees, shrubs and flowers. But that’s not the only way to diversify. A garden would have annuals and perennials that bloom in the spring and in the fall, with flowering azaleas in the shade and bright daisies in the sun.
Diversification is a key strategy for growing your money as well. Financial diversification means spreading your investments among different asset classes, such as stocks, bonds, and cash equivalents. Think of them as the equivalent of the trees, shrubs, and flowers in your garden.
We all hope that every investment we own will perform magnificently, just as gardeners hope that every seed will thrive. But none of us can tell with certainty which investments will go up and which will go down in value. Nor can we be sure that every seed will sprout, let alone bear the prize-winning tomato. By having some of your assets in stocks, some in bonds, and the rest in assets that can be readily converted to cash, like certificates of deposit or money market funds, you lessen the impact if any of your investments lose value.
How Diversification Works
According to FINRA, the Financial Industry Regulatory Authority, the goal of diversification of your money among different markets, sectors, industries, and securities is to protect the value of your overall portfolio in case a single security or market sector takes a serious downturn and drops in price. In short, diversification spreads your risk, while still seeking a strong return on overall investment. Having exposure to a number of different stocks, for example, means your investment success isn't dependent on a single company or sector of the market. The beauty of diversification is that it reduces risk by smoothing out the ups and downs that are bound to happen when some investments do well and others don’t. Mathematical models have shown that a well-diversified portfolio of 25 to 30 stocks will result in the most cost-effective way to reduce overall risk.
If you want instant diversification, think mutual funds. Each mutual fund has a specific investment strategy and invests the money in a pool of many stocks or bonds. The fund could focus on large, well-established companies, or stocks of companies that pay dividends, or even companies in foreign countries.
Be careful, though. Some people invest in several mutual funds that all have similar stocks in them. They think they're diversifying across several mutual funds but instead are putting their resources into similar pots. Three sacks of mixed tulip bulbs won’t give you summer roses or fall chrysanthemums.