Are you currently investing for your retirement? I sure hope so. As you may have guessed, the majority of people are under-invested for their retirement, and still another portion of people have no investments at all! There are two reasons for this: either they have the mentality that they can just continue to work until they’re dead or they truly believe that they don’t have enough money to invest.
For the great majority of the time, both of these statements are completely false. Sure, money may be tight, but there’s almost always an area in the budget where one can cut back on, allowing them to invest at least a little bit into their IRA or 401(k). And something is definitely better than nothing!
Now, there are others that are investing properly into their retirement accounts, but their problem is not that they are lacking money or have false beliefs that they’ll produce a working income forever. This group of people worries if their money will be around for the long haul. They’ve seen the economy go flat and take their investment portfolio with it. Over time, the funds have bounced back, but what if we experience another economic set back? For these people, I would ask them if their investments are properly diversified.
What Does It Mean To Be Diversified?
We all know what the term diverse means. It means “a wide range of” or “a grouping of many different things”. When we speak of diverse populations, we’re saying that there are multiple nationalities and age groups within the group as a whole. It’s diverse. Much the same, when we discuss if a retirement plan is diversified, it’s a question of whether our money is spread around into a wide range of different investments and asset classes. After all, we know that if we invest all of our money into a single stock, there is a much greater chance for our investment to fluctuate, positively or negatively. It’s much more volatile than if we were to invest in multiple stocks.
So what’s the reason for diversification? It’s quite simple really: safety. The idea is that the more diversified investments you have, the less overall volatility you should see in your portfolio. One stock goes up, but the other may go down. Suddenly, rather than experiencing only the upswing, or only the downswing, your portfolio is balanced by both. With this diversification, your investment is now more safe and secure, with a lower chance of dropping dramatically. Diversification reduces risk.
The Professional Opinion of Diversification
I’m sure that all of us have heard of mutual funds. Since many of us don’t have enough money to buy a large quantity of shares from various sectors of the market, especially big companies trading over $500, mutual funds emerged as a way to solve our problems. It was decided that in order to truly allow someone to diversify their investment portfolio, they need to have less expensive options to do so. So how did mutual fund companies solve this problem? Money managers went around and collected money from many different investors, which now gave them the capital to invest in those large companies. By investing in a mutual fund, you are effectively owning a very small percentage of a large fund that owns various stock shares within the market. This is only made possible by the power in numbers, but by investing in this mutual fund, you are now beginning to diversify your retirement account. Depending on the type of mutual fund and its focus, you are now able to own a variety of stocks in various industries and/or countries, all without incurring the same trading costs of buying and selling these individual securities.
Do you realize how many different investments there are in the market? Just within a small company 401(k) plan, you would probably see foreign, small cap, large cap, growth, value, blend, bond, and a few other fund options as well. By spreading your money around into these various categories, many professional advisors would say that you are well diversified. After all, not only are mutual funds diversified in and of themselves, but by investing across various market segments, you should be very well diversified, right? Well, many professionals would say yes, but I’m honestly not so sure.
Think Back in History
Many of us were invested in the market a few years ago when the great recession struck. The DJIA plummeted from 14,000 down to under 7,000 in a matter of months. At that time, your financial advisor convinced you that your money was safe because you were diversified, but what happened to your investments? Did they go up? My best guess would be no. I bet your investments went down by between 30-60%, just like the overall market. Sure, by diversifying your money, you probably avoided total bankruptcy, but was your diversification strategy minimizing your risk? Absolutely not.
True Diversified Investments
Each one of your investments are located within one market: the United States stock market. To me, that is not diversification. As we saw in the example above, when the market goes down, so does your portfolio. So if I’m not satisfied with this type of diversification, then what will get your investments diversified? Just as the word suggests, I would like to see more variety. Don’t just invest in the stock market, invest your money into other areas as well.
Market investments, including bonds, mutual funds, index funds, ETFs, commodities, common stock and/or preferred shares are not tangible investments. An individual can hop onto their computer and transfer some funds from their bank account into an investment account, point and click on a few investment options, and they have officially invested their money. There’s nothing tangible there.
I say that to be truly diversified, you should yes, be invested in the market, but also be invested in other tangible assets. Go out and buy some precious metals. Use some of your money to invest in real estate. And, perhaps you could invest some of your money in collectibles or art that may increase in value as they become more and more rare throughout the future years. Heck, maybe you could even invest in yourself! Start your own business and attempt to increase your initial investment by 15% per year. Only when you invest outside of the market as well as within it are you truly diversified.
This is a guest post from Robert Farrington from The College Investor, a personal finance and investing site dedicated to young adults and college students. Check out his Investing 101 Course to learn how to get started investing.