submitted by Michael Garry, CFP®, JD/MBA, Yardley Wealth Management, LLC
Say you were presented with three investment opportunities: one was expected to return 2%, another was expected to return 7%, and the last was expected to return 10%.
Would you simply put all of your money into the investment that was expected to return 10%? You might be tempted to, but probably shouldn’t.
In order to expect higher returns on your investments, you have to take on additional risk. Since the average investor is risk-adverse, they may want to spread their money out and invest a portion of it in each of these opportunities. This is the concept of diversification.
So how does diversification work?
Pretend that you have a portfolio in which you invested all of your money in one stock, GM. Now say that a news story hits about a manufacturing defect in one of GM’s cars and its stock price drops 3%. Your entire portfolio has now lost 3% of its value.
Now instead pretend that you have a portfolio in which you invested half of your money in GM and half in risk-free T-bills, and now that same news story hits. This time, you’ve only lost 1.5% of your portfolio’s value.
Although a simplified version, this is the general idea behind diversification. Allocating your assets among various asset classes, and to various investments within those different asset classes, can dramatically decrease risks related to firm-specific factors as well as to general economic conditions.
With some amount of diversification, you can decrease the risks more than you reduce the expected returns. This is the so-called “free lunch” of diversification, and it may be the only one in investing!
It’s best to sit down and determine which diversification strategy best fits your needs and risk tolerance and then allocate your assets accordingly.