Why Diversification is Important for Your Finances
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If you’ve ever heard the phrase “Don’t put all of your eggs in one basket,” you will probably understand the idea of diversification and why it is so important for protecting your assets. Diversification is simply the “act of introducing variety.” Though it can be used in a number of different contexts, when it comes to managing your money, there are two main places you should ensure you are using it — your income and your investments. Financial diversification helps reduce risk in your finances and is an important part of making sure that your financial goals aren’t derailed by the unexpected.
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Why diversify my income? When considering income, you probably tend to think of only one thing — how high it is. However, that’s certainly not the only aspect that matters when it comes to how your income impacts your net worth. How much you spend, how high your taxes are, how long you plan to work and a number of other things can make the same income look very different. So can the source(s) of your income.
For example, take two people, John and Mary, who both earn $150,000 per year. John’s $150,000 comes from three different jobs plus from a property he owns that he rents out. Mary’s $150,000 all comes from her job in the form of salary. If a recession were to hit and Mary lost her job, she would be out $150,000 immediately while if John lost one of his jobs, he would still have three other sources of income and not be struggling to replace all of his income at once. John is in a much better position than Mary.
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Why diversify my investments? The same idea holds true when thinking about investing. When you invest your portfolio, you have a number of different asset classes that you can consider, such as real estate, stocks and bonds. Then, within those, you have more options. For example, you could invest in U.S. stocks or European stocks and with bonds, you may select corporate bonds or government ones.
Consider this: If, in 2008, you had invested 100 percent of your portfolio into one asset class, U.S. stocks, you wouldn’t have been very happy when your portfolio dropped 34 percent that year. However, different asset classes often move in different directions at the same time so, if you had diversified and invested 50 percent of that portfolio in U.S. bonds (some government and some corporate), your losses would have been closer to 17.5 percent. While still not ideal, someone who was properly diversified during 2008 would have been considerably happier with his performance than someone who was not.
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Similarly, someone who had held 100 percent U.S. bonds the next year, in 2009, would have been frustrated by his 2 percent return because it lagged the 50/50 portfolio which returned over 10%! You never know which market class is going to be up and which is going to be down so diversification gives you the best risk-adjusted return.
Diversifying your portfolio is more art than science because it depends on a variety of factors like your age, income streams and risk tolerance. However, spending the time to determine which ratio is right for you will pay big in the future.
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