Diversification: What Is It and Why Does It Matter?
When markets feel uncertain, there’s one word that always comes up: diversification.
But what does diversification actually mean? And why is it so important?
What is Diversification?
The practice of spreading your investments across multiple types of assets to reduce risk. In simple terms, it means don’t put all your eggs in one basket. By not putting all your money into a single type of stock or investment, you do not give that investment the power to negatively impact all your assets.
Building Blocks of Diversification
Stocks
Stocks can offer great potential for growth, but they can be volatile and unstable. The value of stocks can fluctuate rapidly, depending on market conditions and political events.
Bonds
Bonds typically offer more stability and income. They operate differently from stocks, which can help balance overall performance.
Cash (Or Cash Equivalents)
Cash is liquid and readily accessible. It is very helpful for quick, short-term needs.
Why Diversification Matters in Retirement
Diversification is especially important when planning for retirement.
When you’re building for retirement, you’re navigating through decades of market cycles. During retirement, diversification can help balance growth with stability.
Diversification helps to prepare you for multiple possibilities.
Common Misconceptions about Diversification
“I own multiple stocks, I’m diversified.”
Owning multiple investments doesn’t mean you’re automatically diversified. If the investments are correlated to each other, they can tend to move in the same direction at the same time, and your portfolio may still be pretty concentrated.
“Diversification lowers returns.”
While diversification can sometimes lower short-term gains, it can also reduce extreme loss. Over long periods of time, managing risk is just as important as growing your assets.
“Diversification doesn’t matter as much once I retire.”
Most people believe diversification is only important while building wealth, and once they retire, the focus shifts. But retirement lasts decades, and during that time, portfolios still need to grow to help keep pace with inflation.
The Big Picture
Diversification isn’t a trend. It’s a core principle of investing. Markets will change, and economic conditions will evolve. Because uncertainty is part of investing, diversification helps to keep things balanced.
