Explaining Diversification

You've probably heard people in fancy suits talk about their "diversified portfolios", but WTF does that actually mean and does it apply to you?

The answer is yes. If you have a 401(k), an IRA, or a taxable investment account, you need a diversified mix of investments (and you don't have to own a fancy suit to create one that works for you).

What does diversification mean?

Essentially, diversification means putting your in various types of investments in order to minimize risk. It's the idea that putting all your eggs into one basket is incredibly risky, but if you put your eggs into many baskets, if one gets dropped and scrambled on the sidewalk, you'll still have your other eggs. Hopefully, the majority of those other eggs will blossom and grow into wealthy chickens.

When we talk about diversifying your investment portfolio it mostly relates to the asset classes in which you are invested. Asset classes include stocks, bonds, real estate, ETFs, commodities, cash and cash equivalents.

It can be really pricey to diversify through purchasing individual stocks and bonds, so most everyday investors use ETFs and mutual funds to achieve an appropriate level of diversification. These funds make putting your eggs into multiple baskets affordable for the average person.

Why is diversification important?

Diversification is important because we aren't investing geniuses who know the ins and outs of every company and spend every waking moment studying the global economy and its multifaceted nature thus rendering us capable of picking only winning company stocks. Who has that kind of time?! Answer: no one.

Picking one or two investments in which to place all of your money is a gamble most of us can't afford. Instead, we use diversification to grow our money over time while mitigating the chance that a few of our investments might suck.

(I don't have a reason for this GIF other than it's Bachelorette season, y'all.)

How do you know if you're properly diversified?

Your mix of investments should be based on your age, your goals, and your risk tolerance. Basic rules of thumb say the younger you are the more risk you can theoretically handle. You are likely properly diversified if you are comfortable with the level of risk you've taken on, if you're invested across asset classes and sectors, and you're comfortable sticking with these investments for the long-term. There are plenty of cool tools online to see if you're properly diversified, or you can ask a financial planner!

You should review your portfolio annually to see if any adjustments or rebalancing is needed. Again, if you work with a planner, they'll do this for you. Diversification is the best way to grow your money over time and minimize your risk. Simple as that.

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