1- Minimize risk
When the market tanked and I had my entire investment portfolio seated firmly (and stubbornly) in market-based mutual funds (“that were sure to rebound,” I told myself…), one bad bet cost me 66% of my total net worth. It was crushing (as I outlined above).
If I would’ve diversified into 3 separate ‘sectors.’ I could’ve had 33% of my net worth in the market, 33% in an online savings account, and 33% in equity on a home, for example, my losses would’ve been tempered. (33% of my total net worth would’ve been $10,000 at that time)
Let’s play this out
Home – If I was able to keep my hypothetical job through the crash and continue paying my imaginary mortgage, the expected loss in value on my home would not have mattered. I simply would not have sold the home, waited for the market to rebound, and either kept the home long-term or sold after the value rose to a more realistic level.
Many variables are at play here with changes in value and payment toward loan principle. So let’s just say for argument’s sake, it was a wash. 33% of my net worth remained intact – $10,000.
Savings Account – If this account remained untouched in a 1% interest online savings account (which is not difficult to come by, now), I would’ve expected to see that account near $11,000 today (10-years later).
This sector would’ve seen a $1,000 increase to $11,000 total… Not too shabby.
Market Investments – Let’s assume nothing changed here with my temperament and lack of education, and that I lost 66% of my invested funds. In this diversified example, that’s a total of $6,667 in losses.
Here, I would’ve been down to $3,333 total.
Summing my 3 fictitious sectors up
If I would’ve diversified my net worth, the generationally terrible market crash would’ve been dampened in impact and ultimately my total portfolio would’ve had a respectable $24,333 remaining 10-years later. A very important thing to consider here is that this model assumes that I did not reinvest in the market after taking the 66% loss…
I did end up getting back into the market and recouped my funds, but still, my point of diversification being a benefit holds true!
No diversification left me with $10,000.
If I would’ve diversified – $24,333. (see the GIF above for my feelings about this mistake…)
2- Generating returns
Diversifying your market-invested funds into different sectors can also have a positive effect on your returns (the money you gain when your investments increase in value).
Let’s use this awesome Fidelity infographic
to illustrate our example. If we pay attention to 3 different market sectors (Information Technology, Industrials, and Financials) in 2017, we can see the benefits of diversifying. I’ll use 2 examples each with $30,000 of investments.
1- Investing your entire portfolio in the Financials sector (improved 6.9% in 2017)
If I had put all of my $30,000 into the financial sector last year, I’d expect to have around $32,070 at year’s end… A 6.9% increase and not too bad. But…
2 – Dividing my $30k equally into the 3 sectors identified above
- $10k in Financials (6.9% increase) would’ve yielded $10,690
- $10k in Industrials (9.5% increase) = $10,950
- $10k in Information Technology (17.2% increase) = $11,720.
With diversifying, I would’ve seen about $33,360, or a $1,290 increase over my non-diversifying self.
The examples above take many loose assumptions into account. Granted, there are fees, a myriad of other sectors and funds to invest in, and human nature that all come into play when determining someone’s financial successes and failures. The examples above are generalities just attempting to prove a point: Diversifying is generally much better than putting all your eggs into 1 basket, so to speak. Consult a pro and start saving now.
Now that we know diversifying has serious benefits, here are a few ways to start diversifying… NOW
Option 1: Diversify within the stock market
Diversifying within the market is to spread your money around to different sectors, indices, types of investments, and geographical areas of the world (to name a few). I’m not going to play an investment expert here but two good rules of thumb are:
Invest in things you know and understand well
If you aren’t well versed, seek help from an advisor that fits well with your values, educates you on the moves she advises and is completely open about how she makes money
While we’re on Market Maxims (…I like that…), here are a few other tips that I’ve used to help advance my positions:
Don’t try to time the market
. Some of the most intelligent people in the world work in finance… and they have a very difficult time with this. Why should I think that I’d be lucky enough to have success? I’m not and I haven’t.
Don’t try stock picking if you’re not extremely well informed. And even then, use caution.
I have used S&P Index funds for the last 8-ish years and they have treated me well. They will mirror the S&P Index, which tends to produce respectable returns. Also, Index funds typically have basement-level expense ratios, which keep more money in your pockets.
Don’t feel the need to invest all of your money at one time. I like to keep cash available and buy in at regular intervals, which helps me avoid the downsides of timing the market (above).
Option 2: Diversify in different investment types
Market crashes are wide-reaching and the most recent one hit me pretty hard. That’s why I have made it a point to invest money outside of the market these last 8 years. Here are a few options:
Real Estate – whether it’s a home or investment property, a portion of your mortgage will go toward equity in that home. Over time, built up equity can be realized by selling the property.
Peer-to-Peer lending – there are many companies that exist in this space today. The point here is that money can be exchanged as a loan without involving the bank. Admittedly, I’ve never done this and I don’t know much about it, but I’ve heard positive and negative things (I’m all ears if you have some experience and would like to comment below).
Pay off your debts – Unlike many of the investments above, this one has a guaranteed rate of return. If you’re paying on a loan that has 5% interest, that’s interest that you’re paying. By eliminating the debt, you’re also eliminating the interest you’d be paying… That’s a net positive with a guaranteed 5% return for the good guys!
Start a business – My personal favorite. There’s no other investment out there that you would have more control over. You can literally manage and manipulate nearly every aspect of this ‘investment.’ And because you have control of many factors, the potential returns here can be huge.
Invest in yourself – You can take a course, earn a certification, or get an advanced degree. All of which could yield a higher income if applied properly.
It pays to diversify. Whether your goal is to limit your exposure or increase your returns, you’d be wise to spread the cash around. Take it from a guy that learned this one the hard way… so you don’t have to
What is your practice when it comes to diversifying your investments? I’d love to hear in the comments below!
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