When people hear the word investing, the first thing that comes to mind is investing in the US stock market. But investing well actually involves much more than that, and successful investors usually have many other kinds of investments in their portfolio.
One fundamental concepts of investing is diversification. The idea behind diversification is that an investment portfolio comprised of many different kinds of assets will be less risky than one that focuses exclusively on one asset. Any asset can suddenly decline in value for a variety of reasons, but it’s much more unlikely that many different, unrelated assets will all decline in value at the same time. The analogy of not putting all of one’s eggs in one basket is often used to explain diversification. And since the mitigation of risk is one of the most important aspects of investing, diversification is promoted by the vast majority of financial professionals as a prudent way to protect investors from risk.
Owning stock from a few different companies is better than owning just one company’s stock, but it does not mean that you are well diversified. It’s not uncommon for entire market sectors, or even for the entire stock market to lose a large portion of its value in a relatively short period of time. Proper diversification requires looking beyond stocks, to other types of investments.
A well diversified portfolio will likely include some stocks, bonds, cash, T-bills, real estate, and other types of assets. The reason diversification works is because these different asset classes are not correlated—they act somewhat independently, and their prices are not directly influenced by one another. That way, when one asset class goes down in price, another will rise or stay level, protecting the investor from losing all of his or her portfolio’s value. Real estate prices, for example, have a low correlation with the stock market. When stocks plummet, real estate prices tend to stay steady, and vice versa, which adds stability to an investment portfolio. For example, while the stock market lost $5 billion in value between 1999 and 2001 in the Dot Com Bubble, US real estate prices gained more than 10% annually over the same period.
How can you determine the proper level of diversification for your needs? There’s no one-size-fits-all investment solution—the level of diversification will depend on your needs as an investor. Typically, younger investors who have a long investment time-horizon can afford to be less diversified, with the hope that they have enough time to ride out any dips in the market. The extra risk they take is ideally rewarded with higher returns.
Older, more established investors, on the other hand, and especially those with large investment portfolios, tend to be more cautious and seek the preservation of capital over excess returns. For them, proper diversification is of the utmost importance in order to control risk, preserve their wealth, and add a level of stability to their investment portfolio.