Everyone has heard about how important it is to "diversify" their investments. Don't put all your eggs in one basket. How do you diversify and when have you diversified enough? Is it possible to over-diversify?

Everyone has heard about how important it is to "diversify" their investments. Don't put all your eggs in one basket. How do you diversify and when have you diversified enough? Is it possible to over-diversify?

Did you know that King Solomon recommended investment diversification? Ok, maybe he didn't directly address investing as we know it today, but consider this... In Ecclesiastes 11:2 he states "give portions to seven, yes to eight, for you do not know what disaster may come upon the land." This is the same as the popular saying today, "don't put all your eggs in one basket." King Solomon was granted wisdom from God and I think we can do ourselves a favor by listening to his advice.

There are 4 different ways we should consider diversifying...

1. Investment type
2. Companies
3. Industry
4. Investment styles

1. Investment Type

There are three main types of investments available to choose from: equities, bonds, and cash. Each type has its own pros and cons to consider. Most investors will, at some time, use each of these types of investments.

Equities are primarily used by investors seeking growth of their investments. They play a pivotal role for anyone investing for 5 years or longer. The longer the time frame you have for investing, the more appropriate that equities become as investment tools. For aggressive investors, it is not uncommon to own nothing but equities in a retirement plan or educational savings account.

Bonds are generally less volatile than equities. Many investors use bonds when they are drawing income from their accounts. The closer a person is to making withdrawals from their account, the more appropriate bonds become for an investor. While bonds generally earn less than equities, they can help reduce a portfolio's volatility. One drawback to some bonds is that their interest is completely income taxable unless in an account that is tax free or tax deferred.

Cash investments are short-term investments such as CDs, T-bills, or money market accounts. These investments are designed to be very safe yet still earn a small interest rate. These investments are great for storing money for those unexpected or infrequent bills. Examples would be any semi-annual or annual payments, auto repairs, home repairs, or medical expenses. This is what we call short-term money. Someone with this type of account can avoid having to charge these unexpected bills on a credit card when in a crunch. Proverbs 21:20 says "In the house of the wise are stores of choice food and oil, but a foolish man devours all he has." In other words, we shouldn't spend everything we've been given. Cash type investments are great tools for storing money for short-term expenses.

2. Companies

A smart investor will never have all or even a moderate portion of their money invested in just a few companies. This is very risky. Ask anyone who had a substantial stake in Enron how they feel about owning just one or two companies. I met a gentleman last year who owned about $80,000 worth of Enron stock before the company went under. Needless to say, he learned a lesson the hard way. There are companies every day that are failing. Even the companies that seem to have everything going for them may eventually run into turmoil. That is the nature of our capitalist system. I personally don't suggest owning individual stocks outright. I think a better option is to use professional money managers. With these accounts, you are often buying about 100 companies or so in a single investment.

3. Industry

Ok, let's say that you own 100 companies. Are you safe now? Maybe. It is also important to consider diversifying across different industries. If you owned 100 companies, but they were all technology-oriented, what do you think would have happened from 2000 to 2002? Almost certainly you would have lost a substantial amount. This is why it is so important to not only diversify in the number of companies you own, but also the industries they are in.

4. Investment Styles

Lastly, it is important to consider having multiple investment styles. Investment style can be broken up into 2 main categories: growth and value. I think it is easiest to explain these two styles of investing by using a baseball analogy.

Growth investing is similar to a player who tries to hit a home run every time they step up to the plate. They want to crush the ball out of the park every time. One problem with your biggest home run hitters, however, is that they are often your biggest strikeout kings as well. This is can be a pretty volatile style of investing.

Value investing is similar to a player who just tries to get on base. They are more concerned with a steady approach. They may not always earn as much as growth-style investing, but historically, they have tended to do better when the ecomony declined. Of course, past performance does not guarantee future results.

Conclusion

King Solomon was right. Diversification can help us to avoid disasters. Smart investors will diversify in all of the 4 methods mentioned in an attempt to attain their financial goals with less risk. If you're not sure if your portfolio is properly diversified, give us a call. We can do a detailed portfolio analysis for you. [contact us] .