Investors often use the term “diversification” when it comes to managing one’s wealth, but what does this term actually mean? Below are some reasons why diversifying your assets is so important.
How Does Diversification Work?
The premise behind diversifying your assets is that it will enable you to enhance your return without having to risk a great deal in exchange. When your wealth is diversified, this means that it is placed in multiple asset classes instead of a single one. For example, experts consider your stock portfolio to be diversified when it has twenty to thirty different stocks throughout multiple industries. But aside from securities, your portfolio could also include things such as real estate, bonds, savings accounts, and CDs (Certificates of Deposit).
Each of these different assets will perform differently depending on the manner in which the economy shrinks or grows, and each provides differing potentials for losses and gains. If you keep all your wealth in a single market, such as real estate for instance, and the real estate market plummets, your wealth could be decimated while those whose wealth is solely tied up in stocks could be in trouble during a stock market crash. But by dividing your wealth into stocks and real estate, your exposure to either is limited and potentially counterbalanced by the other.
Characteristics of Each Asset Class
Below are some characteristics which are common to each asset class:
- Bonds: These assets tend to provide steady returns with a payout that is fixed, but may vary due to falling or rising interest rates.
- Stocks: This investment can provide an excellent return over a long time span, but may fluctuate considerably in the short to medium term.
- Savings accounts and CDs: Unlike stocks, these investments will not fluctuate much in value and will grow gradually as time passes based on an interest rate and specific contractual terms.
- Real Estate: Residential and commercial property tends to appreciate slowly as time passes, but can be rented out to earn monthly cash flow. The downside is that such property is immobile, has high maintenance requirements and the commissions may be steep.
The key thing to understand is that none of these assets will rise or fall simultaneously. When some of them go up, others will go down. This means that an investor who splits his or her money into all of them will be protected and their overall wealth is likely to grow over time.
Why Diversification is So Powerful
The more assets you own, the wealthier you will be. The reason for this is that owning multiple assets greatly increases the potential returns while stabilizing results. Most people own few assets and those that do tend to have them in a single class such as stocks. But truly wealthy people (millionaires and billionaires), rarely have all of their wealth in a single class. Rather, their wealth is invested in multiple assets such as a company they own, real estate, bonds, CDs, and stocks. Their overall risk is lowered while their potential for returns is maximized.
