The typical investor is inundated with investing terms on a daily basis: allocation, diversification, optimization, etc… As a professional that has studied these topics, I understand the frustration that many consumers have when trying to make sense of it. In today’s post we will try to break down the confusion surrounding the topic of “Diversification”.
It may sound complex, but in actuality Portfolio Diversification is simply about spreading the load. The best visual example of “diversification” that I was taught was to envision an architect designing a house. When he/she is designing the second floor it is important to spread the load equally amongst all the supporting walls beneath it, or risk having the house cave in because to much weight is supported by one wall. It works much the same way with your investment strategy. You may have heard the term “all your eggs in one basket”, which is a reference to diversification as well. When looking at how your overall Networth is positioned you need to ask the question of whether you are over concentrated in one particular area? Does Realestate make up a significant portion of your investments? Are you 100% allocated to an index fund following the S&P 500? Maybe you are 100% in cash? In each of the scenarios you are not “spreading the load” and in actuality may be subjecting yourself to excessive risk for the potential return you may get or simply missing growth opportunities in other investment areas.
When thinking about Portfolio Diversification simply revert back to the example of building a house and spreading the load:
- Analyze your current investments to see if you are overweighted in one particular area.
- Develop a diversification strategy so that you are weighted in all of the major areas: stocks / bonds / real estate / cash.
Once your investments are diversified across the major investing areas, then it is time to analyze the specific “asset allocation” of each component, but that topic will have to wait until next time!