Diversification Helps Ensure Financial Sucess

A financial advisor trying to say “don’t put all your eggs in one basket” might tell clients that they need to diversify their portfolios.

Diversification refers to the practice of dividing investments among different types of financial products. The strategy works by increasing the chances that some investments in a portfolio will realize profits, even if others remain flat or lose money.

Investors who practice diversification allocate their money to a variety of asset classes, such as stocks, bonds, bank deposits, real estate and commodities, including gold. Investors further diversify across subclasses. In the case of bonds, investors diversify by purchasing an assortment of bond types, such as those issued by corporations or local, state and federal governments, and those with short-term or long-term maturity dates.

Stocks are classed by such factors as company size, region and sector, such as pharmaceutical or technology companies. Investors who own a cross-section of stocks are better positioned to benefit from a rally in a particular sector, such as emerging markets, and are buffered from losses in another sector, such as financial companies.

The most highly diversified portfolios are those that contain investments that behave differently from each other. The value of bonds declines, for example, when the stock market rallies, while the value of gold increases in times of faltering consumer confidence.

Index mutual funds and exchange-traded funds, or ETFs, are useful diversification tools. For a relatively low minimum investment, an investor can gain exposure to an entire sector, such as all the companies in the S&P 500 index.

Diversification is highly valued by America’s most successful investors. According to a December survey by Spectrem Group, diversification is a key factor in financial decision making. Nearly 90 percent of investors with a net worth of $1 million to $5 million (excluding their home) say diversity and risk are top investment factors.

“Diversification enables investors to benefit from gains in one asset class, while riding out losses in another,” said Catherine McBreen, Spectrem’s Managing Director. “Investors need to periodically review their portfolios to make sure they remain properly diversified over time and also maintain a balance that reflects an individual’s risk tolerance and financial goals.”