The Importance of Diversification!

Diversification is something many people have either heard of and practice very diligently, or something that many investors have no clue is important and expose themselves to unnecessary risk when they first invest their money. The goal of investing is to expose yourself to the highest returns, while taking the lowest risks. Now, stock investing(as I will get into great detail later) is a way that you expose yourself to high potential returns, but also have to take some level of risk when you invest in this. This is why some people prefer sticking to bond investing or real estate investing, something seen as more “safe”. While this may be true, you also are missing out on a great potential ROI(return on investment) that many stocks can provide. 

So the question is, how do investors find the stocks that will outperform others, and avoid the risky ones? Well, the short answer is that you can’t. Picking and choosing stocks and making trades all day long will lead to higher taxes and lower returns in the long run. So what can investors do about this predicament and why would you even invest your money in the stock market if this is true? Diversification is the answer to a lot of these questions. If you can’t pick the “good” stocks and avoid the “bad” ones, then you must buy as many as you can to expose yourself to those stocks that will perform extremely well, and those will offset the ones that don’t perform up to par. Of course, there will be years where the market experiences downturns or recessions, however overall the market returns about 10% per year, like I mentioned earlier. The graph below will show you this upward trend that the S&P 500 index has experienced, which is the 500 companies with the highest market capitalization(total value of a company’s stock) in the United States. 

Speaking of the S&P 500 index, let me introduce something to you called an index fund. It is simply a collection of stocks that are together in one fund for you to buy that seeks to passively track an index or sector. You can buy an S&P 500 index, for example, and you would own all of the stocks in that index. This makes investing simple for people so that you don’t have to buy portions of every stock in that index by themselves. It will save investors a lot of time and money. I will expand even more on the topic of index funds, other types of funds, and the types of fees associated with each later on when I talk about stock investing, but I wanted to introduce index funds now, as they are a great and cheaper stock investment for retail investors looking to invest for the long haul and not put too much effort into it. Right now, I want you to understand the importance of diversifying the type of stocks you have in your portfolio and letting the market do what it does best… grow. My personal finance professor always says that the market will continue to grow because we as humans continue to improve. The leaders and employees of public companies are always looking for the latest and greatest technologies and ways to increase efficiency, and that will help the value of all the companies in the stock market continue to increase in value. 

If we are talking about true diversification you may ask if it is smart to have all of your money in stocks. The reason I am primarily talking about stocks in this chapter is because the target audience I am wanting to help in this blog are college students and young adults. As you get older and approach retirement, you may want to switch some of your investment choices to include bonds to avoid some risk when you take money out of the market for retirement, but even bonds are not completely risk averse. Some people also may choose to invest in Real Estate along with their stock investments. Diversifying beyond stocks alone can help you avoid risk in rough times for the economy, however when you are young and have a long time horizon it is typically best to stick to stock investing and riding out the volatility of the market. This will lead to the greatest possible returns over time.