What is Diversification!?

On to discussing the third reason you aren’t rich. The lack of diversification.

Diversification is a difficult topic because there are so many things that go into it. Among the most important are age, when you plan on using your money, and how much of a risk taker you are. There are three main classifications when it comes to investing your money.

STOCKS Stocks are the most volatile investment, but in the past they have produced the greatest returns. In the 45 years preceeding 2005 stocks averaged a 10.5% return. Their best year produced 38.5% returns and their worst year lost 28.4%. 12 of the 45 years ended in a loss.

What does that mean for you?

  • If you had invested $1000 in 1960 and kept it there until 2005 then you would have $89K
  • If you invested $1000 and kept it only for the best year then you would have $1284
  • If you invested $1000 and kept it only for the worst year then you would have $615
  • 27% of the years that you invested ended lower than the year before

So, if you have 20+ years before you need your money then you want to lean towards more stocks. If you need your money in 5 years then stay away! In the same sense, if you are a risk taker then you can lean towards stocks. If it gives you an ulcer thinking about a drop then don’t! As we all have learned from the market lately, if you need your money after a huge stock drop then the losses you can experience can be devastating. Those who can wait it out have unrealized losses right now, but eventually they should gain that back.

Usually people overestimate the amount of risk they are willing to take. After the recent market drop, it is easier to figure out if you are a risk taker or not. Did you liquidate your account? If you did then you are a play it safe kind of person. Did you think about taking it out and force yourself not to? Then you are middle of the road. If you didn’t even dream of taking it out then you are a risk taker.

BONDS Bonds are the “middle of the road”. Use them as you are getting closer to needing your money (5-10 years) or if your stomach can’t handle the risk of stocks. They get good returns but are not as volitile as stocks. In the 45 years preceeding 2005 stocks averaged a 7.1% return. Their best year produced 31.1% returns and their worst year lost 8.1%. 5 of the 45 years ended in a loss.

What does that mean for you?

  • If you had invested $1000 in 1960 and kept it there until 2005 then you would have 22K
  • If you had invested $1000 and kept it only for the best year you would have $1331
  • If you had invested $1000 and kept it only for the worst year you would have $919
  • 11% of the years you invested ended lower than the year before

As you can see, you would end up with a lot less over the long run, BUT, only 11% of the years end in a loss vs. 27% of the years so your stomach can rest easier. If you need the money in the next 5-10 years then investing this way will provide better protection against having to pull it out at a loss.

CASH EQUIVALENTS Cash equivalents (CD’s, money market accounts) should be used when you will need the money soon. Your emergency fund and the money you are going to be spending in the next 2-5 years should be in this account. In the 55 years preceeding 2005 an average cash account earned 5.31% interest.

What does that mean for you?

  • If you had invested $1000 in 1960 and kept it there until 2005 then you would have 10K
  • You never end in a loss

After inflation, there isn’t usually much left in a cash equivalent account, but that is not to say that they are not useful. They usually bring more money than a regular savings/checking account. The key is to keep the APR above inflation (typically 3%).

The calculator at Smart Money is very helpful in trying to figure out your personal diversification map.

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