Do not put all your eggs in one basket – that’s diversification. Simple as that.
An investor should own cash, bond Mutual Funds, equity Mutual Funds, and real estate (residence). This is diversification – having investments in multiple financial instruments that provide different levels of risk and reward. Diversification reduces the risk in your portfolio – when some investments are down, others will be up. It is the same reason buying a Mutual Fund or a basket of stocks is better than owning only one stock.
Ram is very proud of his company’s employee stock option program. He likes his workplace so much he has all his investment in the company stock. There are a lot of people who do this. Globally there have been many instances where such blind faith has proved wrong with disastrous consequences.
When times are good and your company is doing well, you will get promoted and get a pay raise. All the while company stock will keep going up, and you will feel like a rock star. But when times turn bad, you may lose your job when the company stock price is falling, and you will feel sad. That’s the problem with putting all your eggs in one basket (in this case your employer), you are dependent on that one basket performing well.
Think of diversification as a the different spices in a spice box. Its only when all the spices come together in the right proportion that you have a tasty meal.
People have known about diversification for a long time:
In the bible:
But divide your investments among many places,
For you do not know what risks may lie ahead.Shakespeare:
My ventures are not in one bottom trusted,
Nor to one place; nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.
We all practice some form of diversification, especially in cash management. Think about it, we keep money in a few bank accounts (if one bank goes under we won’t lose it all), or save cash in a few different places (if one spot gets robbed we won’t lose it all). That is diversification too.
So that leads to the question, how much should one diversify? As a rule of thumb an individual should have investments in multiple asset classes (equities and bonds through mutual fund, real estate etc). Within equities an investor should have investments in domestic (Indian) as well as international (US, Europe etc) mutual funds. Test your diversification mojo here.
Now that we know we should diversify our investment portfolio, how much of which asset should we buy? For that read about asset allocation.
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