Photo: Henry Blodget
Even the casual investor would recognise this go-to mantra of the personal finance industry: “Diversify. Diversify. Diversify.”You might prefer the layman’s phrase, “Don’t put all your eggs in one basket.” But at any rate, the message is the same: Spread out your wealth if you want to give yourself a cushion in case something goes wrong.
The problem is new investors sometimes misinterpret this advice as a green light to snap up stocks in as many different companies as they can afford.
This is wrong.
Diversification is all about investing in different types of assets, known commonly as classes. Experienced investors will likely roll their eyes at this, but given the rate of financial literacy in the U.S., this is a distinction worth spelling out.
Ask anyone about investing and chances are they’ll bring up stocks…and not much else. It’s little-known classes like bonds, treasuries, money market funds, international stock mutual funds and exchange traded funds that you should be aware of as well. Each has its own set of pros and cons to consider –– all of which you should discuss in detail with an expert –– but the point is that there is literally no asset class so perfect that you should rely on it alone.
Think about it. If you throw all your weight behind stocks in a dozen companies from the S&P 500, what happens when the market tanks again? You’ll have used your life savings to buy a one-way ticket to the poorhouse –– not to mention how much cash you’d bleed along the way in trading fees.
This same advice goes double for mutual funds. As noted by Brian Breidenbach, CFA, in a report by the Consumer Federation of America, investing in a bunch of different mutual funds can sometimes give a false impression of diversity.
“You may own multiple funds but find, on closer examination, that they are invested in similar industries and even the same individual securities,” he says.