Most investment advisers, including the U.S. Securities and Exchange Commission, advocate diversification of your assets as one of the bedrock risk management strategies for your portfolio. It's the old "don't-put-all-your-eggs-in-one-basket" mentality. Diversifying your portfolio across a number of different investment categories, such as stocks, bonds and cash equivalents -- and within categories, such as stocks from different kinds of companies and a mix of corporate and government bonds -- can help reduce your risk. But there can be some disadvantages to diversification.
Diversification reduces your risk by spreading it around. For example, if you put all of your money into a single stock, and that stock tanks, you could lose your entire investment. If you invest your money in five different stocks, and one stock tanks, you have your other stocks to keep you from losing everything. Diversifying your assets helps keep you from striking out, but it also keeps you from hitting a home run. For example, if you invest your money in five different stocks, and one takes off, the other four stocks hold back your total return.
You typically have the option of investing through a full-service broker, a discount broker or an online broker. While each type of broker has a different commission structure, they all charge commissions or transaction fees. Putting all of your money into a single investment typically results in a lower total fee than investing the same amount of money spread over a number of different investments.
One challenge of diversification is trying to determine when your assets are diversified enough. Different investment advisers offer different recommendations, but there is no definitive rule for how much diversification is enough. The USA Today website notes that the benefits of diversification tend to decline significantly after 16 stocks. Chasing after diversification can stretch your portfolio too thin, make you lose focus on how your money is invested, require too much time and energy to manage and be too expensive to maintain.
Diversification of your assets can help reduce your risk, but it does not eliminate them. As in the computer world, "Garbage in, garbage out." If you invest in a number of stocks that all turn out to be stinkers, your portfolio will still lose money even though it is diversified. Diversification neither guarantees a profit nor fully protects you against a loss.
- National Association of Government Defined Contribution Administrators: Asset Allocation is a Diversification Strategy
- Shares Investments: Diversification – Do’s And Don’ts
- CNN Money: Spread Your Money Around
- Zuk Financial Group: The Pros and Cons of Diversification
- CNN Money: The Dangers of Over-Diversifying Your Portfolio
- USA Today: A Diversified Portfolio Needs More Than Four Stocks
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.