Investment diversification, simply said, is “don’t put all your eggs in one basket.” This is the traditional approach to investing that you’ll see promoted by many financial advisors and popular personal finance magazines and investment books.
Here’s the idea behind investment diversification. Suppose you invest $10,000 in five different investments for twenty years. The results are below:
- $2,000 in a high risk investment becomes worthless
- $2,000 in a risk level four investment earns 10% and grows to $13,455
- $2,000 in a risk level four earns 8% and grows to $9,322
- $2,000in a risk level three earns 6% and grows to $6,414
- $2,000 in a risk level one investment earns 2% and grows to $2,972
You invested $10,000 which grew to $32,163, which means, on average your investments earned a 6% annualized return. Not bad.
Investment diversification is important. I advise you do it. I also advise you understand its limitations.
The premise behind choosing to diversify your investments is that if you do it properly, you will earn an average return of let’s say six to seven percent a year. Financial planners will run a retirement plan projection for you using a rate of return based on this assumption. They often neglect to account for a margin of error.
The impact of a margin of error is best explained with this excerpt from the book The Black Swan:
“You would take a different set of clothes on your trip to some remote destination if I told you that the temperature was expected to be seventy degrees Fahrenheit, with an expected error rate of forty degrees than if I told you that my margin of error was only five degrees.”
Diversification does help reduce investment risk, but you must remember that the long term results of a diversified set of investments are far from certain.
Adding additional investment risk management techniques to diversification can improve the odds that your investments will achieve the results you need them to achieve so you can reach your financial goals.
