How Investment Diversification Makes You Rich

how investment diversification will make you rich

By 2002 your $10,000 dropped almost in half. You end up with $5,700. If you have the guts to stay invested for another year, you would earn back some losses and end up with just under $8,000. But the reality is most investors would have already bailed.

At the end of the day, you don’t know what is going to happen in the market. If during this same period you had invested in a diversified portfolio of 50% in international stocks and the other 50% in bonds, you would have hedged your losses.

In fact, by the end of 2002, you would have only lost $400. And if you stayed invested through 2003, you would have ended up making over $1,000. All thanks to diversifying your investments. You can see this in the investment diversification chart below.

Some might argue that you are robbing yourself of higher returns by following this strategy. This is true only in the case that you pick the winners every single year. As it stands now, I know of no investor, not even Warren Buffett, who picks a winning stock every single year without fail.

Your best bet for success in the stock market is to invest a portion of your money into each of the sectors equally so you can be diversified. By investing in a well diversified portfolio, you are guaranteed to pick the winners every year. You will also be picking the losers, but this is actually not a bad thing.

How would this investment diversification strategy look and what would your return be? I’m glad you asked. Let’s look at a diversified portfolio example.

How Investment Diversification Makes You Rich

This diversified portfolio example takes 1/7th of your money and invests it in each of the sectors listed. The chart shows that an equally weighted portfolio (the white boxes in the chart) runs in the middle of the pack, which is to be expected.

The portfolio has healthy returns and doesn’t require you to pick the winner each year. As noted above, you will be guaranteed to pick the winner each year since you will own a piece of each sector in the market.

You might look at the equally weighted portfolio and see that the annual returns vary a great deal. While this is true, the idea is that by investing in this type of portfolio you are limiting your losses. Note that I said you are limiting your losses, not removing losses altogether.

You could lose money over the short-term, this is inevitable. But you need to keep your focus on the long-term because the long-term trend of the stock market is up.

Here is how $10,000 invested in each sector would look at the end of 20 years.

How Investment Diversification Makes You Rich

In all cases you would have grown your money nicely over the past 20 years. But many of you might point out that the well diversified portfolio ranks near the bottom of the pack for those 20 years, defeating the point of an investment diversification strategy.

While this is true, you have to remember that the majority of investors allow emotions to make decisions for them. In the real world, most investors sold out after 2008 and didn’t return until 2012 at the earliest.

I point to this because when I was working at a high net worth planning firm, our new clients at the time were still not in the market and were only considering putting money back in. So what would this look like?

Let’s say you invested $10,000 in 1997, sold what was left at the end of 2008 and invested that amount back into the market at the start of 2013 through 2017. What does your return look like?

How Investment Diversification Makes You Rich

You would still have made money thanks to the recent bull market, but you would have much lower returns than if you invested in a diversified portfolio and stayed invested for the long-term.

Your Plan For Investment Diversification

So what is the easiest way for you to become diversified? While you could slice the various benchmarks like I did above, there are some much simpler options out there for you.

Step One: Know Where You Stand

Your first step is to figure out how diversified you are. The best option here is to sign up for Personal Capital. With your free account, they will show you how diversified you are, create an investment plan for you, show you how much you are paying in investment fees, and help you see if you are on track for retirement.

I love how thorough and easy to use they make checking up on my investments. My wife loves them because she isn’t a numbers person and seeing how our savings relates to our future retirement makes it real for her. Click here to learn more about Personal Capital.

If, on the other hand, you want a more manual option, you can use Morningstar’s X-Ray Tool. You will need to enter in your holdings’ ticker symbols and the amount of the investment. From there, Morningstar does the rest for you.

While this option is good, you will have to manually update the numbers on a regular basis. So unlike with Personal Capital where everything is always updated to the minute for you, with Morningstar, you will have to re-enter everything every time you want to review your asset allocation.

Step Two: Make Changes

Once you understand your asset allocation, your next step is to begin making any needed changes if you aren’t diversified enough. Using either of the services above will show you where you need to add money to better diversify your portfolio.

But it doesn’t end there. You need to make sure you stay diversified going forward as well. This is where my book, 7 Investing Steps That Will Make You Wealthy, comes in handy. It will walk you through the steps to follow to ensure you are a successful investor.

Now let’s say you understand the importance of investment diversification but don’t have the time or interest to do it yourself? Luckily there are a few options for you.

The best two in my opinion are Betterment and Wealthsimple. Both are robo-advisors that will invest your money in a fully diversified portfolio, as well as reinvest dividends, rebalance, and tax-loss harvest your holdings.

What all that means is you can be completely hands-off and they will do everything for you. You can sit back and relax knowing you are in a diversified portfolio and are invested for the long-term.

Final Thoughts

If you read the magazines dedicated to investing or even watch the 24-hour investment news channels, you will quickly become overwhelmed with all the investing options. Investing doesn’t have to be complicated and neither does investment diversification. It’s actually very simple: invest in a well diversified portfolio with low cost investments, and stay invested for the long-term.

We’ve covered the importance of investment diversification in this post, and I’ve spoken about fund expenses in my outrageous fees post.

As for the long-term, you need to stay invested in the same mutual funds or exchange traded funds all the time for many years. This doesn’t mean sell out when the market drops, or your mechanic tells you about a hot new stock. If you stay invested through the ups and downs then over time you will be in a good place financially.

Just think of your investments like a raft in the water and just ride it out. With investment diversification, the waves will be much smaller than they would be if you keep jumping in and out of the water, trying to time the waves.

The following article was republished with permission from Money Smart Guides.