Diversification: It’s Not Always “Trendy”, But It’s Usually Right
You’ve heard it over and over: Investing is all about diversification. By spreading your savings over many different types of assets, you stand a greater chance of investing success. Why is that?
Well, the simple and common answer is that by adding diversity you reduce your risk. In other words, by putting your eggs into several different baskets, if one basket is harmed, the rest of your baskets will likely be unharmed.
I’m going to be honest: Diversification is not flashy, or trendy. It’s just a boring, basic, foundational principle of investments, and a really important one, especially for those of you who are in the retirement phase of life.
I’m going to share an important example that will help you understand the point I am trying to make. Please bear with me through this…it may seem redundant, but what I am getting at is very important to grasp.
Imagine you plan a week-long vacation with your family. In an effort to prepare for any number of weather conditions, what do you do? No-brainer! You pack some clothing for warm temperatures as well as some clothing for cooler temperatures. Why? Because climate is fairly difficult to predict with accuracy, having a number of options means you’re more likely to be comfortable and enjoy your time. Of course, the downside of this strategy is the unused clothing you had to drag around the airport. Only when the temperature drops is it easy to remember why you took the time to diversify your wardrobe and insulate yourself from the cold.
I think you see where I am going here. Just like when you’re preparing for a vacation with unpredictable weather, there are inevitably going to be times when you feel like your investment portfolio is dragging around assets that are underperforming. But, when the financial market drops, it’s easy to remember why you took the time to diversify your assets and insulate yourself from larger risks.
The truth is, last year, 2014, was a bit like that; conservative, highly diversified investments performed like an unused sweater in the tropical heat.
By diversifying your investments in 2014, you did not receive the flashy, trendy higher risk earnings that the Dow Jones took in of 13.7%. Why not? You were diversified, that’s why. By diversifying your assets among many different types of companies, both here and abroad, you successfully protected yourself from high risk, which also cost yourself much of the 13.7% of return reported by the media. That never feels good, I know.
Please let me remind you why you chose to diversify: Had you been exclusively invested in the same Dow companies in the years 2000, 2001, and 2002, you would have experienced your portfolio drop by 22%, 12%, and 23% respectively. This is a total of a 57% drop, for those who are keeping score. If we have years like that again (and we inevitably will) you’ll be desperately wishing that you would have diversified.
Investing correctly by diversifying pays big dividends over the long-term, but truthfully, it often feels downright frustrating in the short-term.
Having many different eggs in your investment baskets will dramatically increase your odds of a great outcome, but it doesn’t make the journey to your destination the parxt you’ll want to write home about. Just hang in there, especially if you’re at or near the retirement phase of your life, I’m confident you’re doing the right thing.