The Value of Diversification

Financial diversification means you don't have all your eggs in one basket. If you have all of your money in one company stock and that company goes bust, you could literally lose all of your money. Even if your money is diversified among stocks in a well balanced fund, if the stock market crashes all of your money is at risk. However, when one class of assets falls, another class will be simultaneously moving up. Therefore having your investments diversified in a combination of stocks, commodities, real estate, etc., reduces your risk substantially.

In addition to higher yield/risk investments subject to market fluctuations, you should have a significant portion of your money in fixed income, such as guaranteed treasury securities and CDs. As you get closer to retirement, a larger percentage of your money should be safe, in fixed income investments.

Let's take a look at three examples of diversification at various levels of risk from one of our favorite investment companies, AssetBuilder. We'll choose aggressive growth, stable, and capital preservation portfolios:

Model Portfolio 14: Aggressive Growth
Fixed Income: 8%
US Large Cap: 16%
US Small Cap: 8%
REIT: 13%
Commodity Index: 11%
International: 22%
Emerging Markets: 22%

Model Portfolio 8: Stable
Fixed Income: 49%
US Large Cap: 13%
US Small Cap: 5%
REIT: 7%
Commodity Index: 6%
International: 10%
Emerging Markets: 10%

Model Portfolio 6: Capital Preservation
Fixed Income: 67%
US Large Cap: 9%
US Small Cap: 3%
REIT: 5%
Commodity Index: 4%
International: 6%
Emerging Markets: 6%

Notice that regardless of the level of growth or stability inherent in the portfolios, each is very well diversified. You should aim to be equally diversified in your own investment strategy, and use index funds for each asset class whenever possible due to their better earnings and lower fees.