Contributing money to a retirement account or a personal investment portfolio is a common way to build wealth to provide for your family in the future, but investments have the potential to lose value. Diversification is an investment strategy where you purchase many different investments so that you don't suffer major losses if a few investments perform poorly. While diversification can help you avoid the hazard of putting too many eggs in one basket, it is not without its challenges.
Working with a Small Amount of Capital
When you are just starting as an investor, you may not have a large amount of investment capital to work with. For example, individual retirement accounts are limited to contributions of $5,000 per year for those under the age of 50. A small amount of working capital can make it more challenging to diversify, because you may not have enough money to purchase as many different investments as you want. Stock brokerages also typically charge you fees for each investment that you buy or sell, so attempting to buy too many investments with a small pool of capital can result in fees that are a significant percentage of your total investment. Mutual funds, which are professionally managed investments that hold a variety of underlying assets such as stocks and bonds, offer a way to gain diversification without actually buying many different investments yourself.
Diversifying by Industry, Company Size and Country
Buying stock in many different companies provides a basic level of diversification, but the sheer number of investments that you have is not enough to ensure a high level of diversification. For instance, if you buy stock in 50 different companies, but they are all U.S. companies that are involved in the electronics industry, your entire portfolio could sink if the electronics sector happens to perform poorly. Spreading out investments across large, small and medium-sized companies in different sectors of the economy is key to gain true diversification. Investing in both domestic and foreign assets can avoid betting all of your money on a single country's economy.
Diversifying Outside the Stock Market
Diversification is a term that is usually used when talking about stock investments, but putting all of your money into the stock market violates the goal of diversification. Choosing sound investments outside of the stock market is one of the challenges of diversifying personal wealth. Holding a mixture of stock and non-stock assets, like real estate, bonds, savings accounts, certificates of deposit and precious metals increases diversification.
Sticking to your Guns
Diversification tends to spread your risk across the entire stock market, so your gains usually follow the overall direction of major stock market indexes. With a diversified portfolio, you are less likely to experience huge losses, but you are also less likely to see big gains. Resisting the temptation to sell your holdings and chase quick gains is one of the biggest challenges of any investment strategy. Active stock trading is a highly risky activity because stocks can fluctuate unexpectedly in the short-term even if they trend upward in the long-term. Therefore, active trading undermines the purpose of diversification: reducing investor risk.
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