AMES, Iowa -- Risk is inevitable with investing, but diversification can help reduce some of this risk. “Two adages accurately sum up diversification – don’t put all your eggs in one basket and there’s safety in numbers, ” according to Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).
Swanson cites the recent example of many Enron employees who put all their retirement “eggs” in Enron stock, ignoring both adages. When Enron went into bankruptcy, their retirement funds were wiped out.
And according to Craig Goettsch, director of Investor Education for the Iowa Insurance Division, “One of the most common mistakes I’ve seen as a securities regulator is the failure to diversify. A high percentage of persons we surveyed don’t grasp the need to spread their risk.”
The goal of diversification is to put your money in various investments so that if one investment loses money, the other investments may make up for those losses.
“Investing in one security, as many Enron employees did with their retirement funds, can result in disaster,” Swanson says. “But if you invest in several different securities, the impact of any one investment on the portfolio’s return is not that significant, even if that security’s value goes to zero.”
For example, Swanson explains, in a portfolio that includes equal amounts invested in 15 stocks, if one stock becomes worthless and the other 14 stocks in the portfolio average a 12 percent return, then the portfolio’s return would be 11.2 percent. “So, there is safety in numbers.”
And you should diversify your investments both by selecting a variety of asset classes, such as stocks and bonds, and a variety of securities within one asset class. Have some of your investment dollars in a mix of cash, stocks, bonds, and possibly other asset categories and then also diversify within each of these categories.
“You are not diversified if your portfolio consists of stock in one or two companies or in companies in the same sector of the economy,” Swanson says. Different industries, such as oil firms and retail firms, may act differently to changing economic conditions. For example, when oil prices increase, oil firms benefit but retailers may lose business because consumers have less money to spend after filling their gas tanks.
Likewise, fixed-income investments are not diversified if you have only municipal bonds. “Fixed-income investments should include both government and corporate bonds and possibly some international exposure by having bonds in companies that operate in other countries” Swanson says.
To adequately diversify with individual stocks and bonds, you need enough money to select a variety of investments. Mutual funds are a way for even the small investor to become diversified. A mutual fund pools dollars from many investors and assembles a portfolio designed to achieve a specific investment objective (e.g., growth). “If you wisely pick the right funds you can take a small amount of money and get diversified via mutual funds,” For example, select a mutual fund that invests in both stocks and bonds.
Swanson says that time period is another type of diversification that is often overlooked. “The inclination is to “time” buying and selling but this is very difficult, if not impossible, to do. It is easier to be invested for a longer period of time over different market cycles. Although there may be fluctuations over the short term when investing in stocks (for example, stocks lost 22 percent in 2002 but were up 29 percent the next year), by being invested over a longer period of time, these fluctuations can be smoothed out.
“Done properly, diversification can reduce much of the total risk of investing. Even with a relatively small amount of money, all investors should diversify their investments, whatever their goals. Diversification is a cornerstone of wise investing,” Swanson concludes.
The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors. It is funded by a grant from the Investor Protection Trust (IPT). The IPT is a nonprofit organization devoted to investor education. Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions. www.investorprotection.org.