When it comes to investing, you’re likely to run into a lot of jargon. If you’re at all like I was three years ago, you may find your eyes glaze over when you see terms like diversification and allocation. I certainly felt like it was a completely different language! However, after taking a little time to read around these terms, I was encouraged to find that investing concepts are not as complicated as they may seem at first.
To help you get more comfortable, I’m going to demystify some terms, starting with the word diversification. So, what does it mean to be diversified and why does it matter?
Spread the Love
At its simplest, diversification is about not putting all of your eggs in one basket. I came up with a silly example to show why this is so important. Let’s say you have all of your money invested in commercial airline stocks such as United Airlines (UAL) and American Airlines (AAL).
Now imagine that a totally new form of transportation is invented with the result being that no one uses commercial air to get from one place to another. If that were to happen, airline companies’ stock value would decrease dramatically and you would lose a lot of money because you had all your money invested in one industry that became obsolete.
It All Comes Down to Risk
Conversely, when your investments are diversified you’re less likely to lose all of your money. Diversification can mean investing in different industries, different countries, different currencies and different investment vehicles. If something happens in one industry or country, you won’t be as devastated because it’ll hopefully only affect a small percentage of the investments you own. Diversification can mitigate and remove a lot of unnecessary risk from your plate.
Don’t Forget Allocation
As above, a lower risk, more diversified portfolio can be achieved by investing in a range of different investment vehicles such as stocks, bonds, and cash. This is referred to as asset allocation.
Cash is the least risky of the three asset classes because it doesn’t really increase or decrease in value, other than as a result of inflation. However, it doesn’t attract high returns. Stocks are typically the most risky of the asset classes–it’s possible to generate both high returns, and big losses–and bonds fall somewhere in the middle. Generally, bonds and stocks move in opposite directions in the market. In other words, when stock prices go up bond prices typically fall and vice versa (however, they can also rise together). This is why your asset allocation is another important aspect of diversification. Your asset allocation allows you to determine a risk profile that you’re comfortable with in the context of your personal circumstances.
So, in summary, having a mix of stocks, bonds, and cash in addition to investing in different countries, markets and industries is a great way to mitigate risk and create a diversified portfolio. Most investors can’t afford to achieve diversification by buying up lots of individual stocks and bonds, so mutual funds present a cost-effective means to do so. You can read more about this in another of my articles, How I Fell in Love with Index Funds.
This article was originally published on gogirlfinance.com.