The Importance Of Investment Portfolio Diversification

Published: 24th July 2009
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Part of the importance of investing is maintaining your purchasing power. With "safe" funds, you rarely earn an interest rate as high as the inflation rate, which means you're losing purchasing power over time, even though you aren't likely to lose the money you have.

For your investment portfolio, you should also internalise the importance of diversification. There are very few, if any, stocks or funds that are guaranteed to be 100% safe, so putting all of your money into one investment is a dangerous move. Diversifying your investment portfolio balances out this risk by having some investments that are very safe and some that are quite risky but have a good potential payoff.

The other factor you should keep in mind is that your investment portfolio can generally earn money one of two ways: through dividends and through capital gains. With dividends, the company or mutual fund is usually large and rewards shareholders by splitting some of its profits with them. Capital gains are what most people think of when they try to invest: buying a stock when its price is low and selling when the price is higher, making all of your shares worth more than when you first purchased them.

Mutual funds are often recommended for investing newcomers or those without a lot of time to monitor their investment portfolio. These are professionally managed and typically require you to pay them a fee, which is simply a percentage of your holdings. Mutual funds are very useful for the easy diversification they provide, and because they don't need the kind of close attention that other investments do. Nevertheless, mutual funds are being supplanted by something called an ETF, or Exchange Traded Fund.

An ETF is essentially the best of both worlds, when compared to stocks and mutual funds. It has the easy diversification of a mutual fund, but it can be publicly bought and sold at any time during the trading day like a stock. An ETF is generally lower cost, and can factor into a number of investment strategies, either as a long-term investment or one requiring market timing, such as a commodity ETF. Most ETFs are index funds, which are funds that invest in a certain sector of the market, or in a certain region. These are a beneficial part of any investment portfolio.

Stocks and bonds round out the typical investment portfolio. Stocks are simply shares of a publicly traded company. You'll want to invest in small cap, mid cap, and large cap stocks, stocks with dividends and stocks with potential for growth, long-term value stocks and stocks based on timing. For bonds, which are fixed-income investments with an interest rate, you'll want some that are safe and simply give you back your principal plus interest, and you'll want others that are tagged to the interest rate when it's moving.

Your investment portfolio relies on diversification to really be effective while minimizing your risk. It's never a good idea to put all your money in just a few funds, but if you must, put it in index funds or ETFs that are diversified themselves. If you vary your investment portfolio and choose investments wisely, you'll do well as an investor.


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