That's because any time all of your money is concentrated in one or two investments, your financial security depends entirely on the strength of those investments. And no matter how sound an investment may be, there will be times when its market price falls, or it yields less than the rate of inflation, or both.
For example, if your life savings are in certificates of deposits (CDs) paying 3%, while inflation is also around 3%, you're facing a loss of buying power. Or if you own hundreds of shares in a company that loses money, cuts its dividend, and drops in value in the stock market, you'll be short dividend income and perhaps part of your original investment if you sell your shares.
THE FIRST STEPS
If you put some of your long-term investment money into fixed-income investments like corporate or municipal bonds, you may also want to make equity investments like individual stocks, stock mutual funds, or stock separate accounts. If some of your short-term investments are CDs, you may want to put the rest in money market funds or US Treasury bills.
THE SECOND STAGE
Many financial advisers suggest that real diversification also calls for international investments. Because world economies respond primarily to what's happening in their own countries or regions, putting money into overseas markets is a good way to balance what's happening at home and take advantage of the growth potential in those markets.
Achieving diversity isn't a one-shot deal. In analyzing your portfolio, ask yourself the following questions to measure where you are and what's next:
- What resources have I committed to buying stocks, bonds, mutual funds, variable annuities, real estate, and other investments?
- What are those investments worth in relation to each other? How about in comparison to last year? Five years ago? Ten years ago?
- What investments have I made lately? Are they all basically the same? Or am I continuing to diversify?
- What am I going to buy next? Why?
THE VALUE OF FUNDS
Because mutual funds and variable annuities pools investors' money to make their purchases, they can generally achieve a breadth of diversification that no individual can. However, you do pay annual asset-based fees on these investments, which you don't on individual securities.
ONE MORE THING TO REMEMBER
Diversification is especially important if your employer's stock is cyclical, which means its price is strongly influenced by changing economic conditions. Hotel stocks, for example, tend to be depressed in a slow economy because people travel less. If that's the case, you may not want to put too much money into other stocks that behave the same way.
To extend the idea one step further, you may want to think twice about building a portfolio full of stocks and bonds in companies that are in the same business your employer is in. If the pharmaceutical business declines, for example, and all you own are drug company stocks, you'll really need an aspirin.
DIVERSIFICATION FOR THE LONG HAUL
Diversification isn't the same as buying randomly. If anything, it's the opposite, because it means buying according to your strategic plan to get the right mix of investments. But there's nothing wrong with achieving diversification gradually. If you decide to expand your large company holdings because that part of the stock market seems poised for steady growth, you can do it and think about adding to your small-company portfolio in the months ahead. The right level of diversification for you at a given time depends on a variety of factors, including where you are financially, what your goals are, and what the market is doing.