The importance of diversification in investing cannot be emphasized enough. When divvying up all your investment eggs, it’s important not to put them all in one basket. So what does a well diversified portfolio look like?
Different asset classes. An asset class is a different type of investment such as a stock, bond, or money market account. Each of these asset classes serves a distinct purpose according to its risk tolerance, duration, and rate of return. Limiting your investments to only one of these assets could set your portfolio off balance.
Diversification within asset classes. If an investor were to buy stock in only one company and then that company failed, he would lose all his money. That’s why it’s important to own stock in several companies. The easiest way to do this is to buy a mutual fund which is a managed fund owning stock in hundreds of companies across different industry sectors.
A common mistake among investors is to hold different accounts at different institutions, thinking that this is diversification. This could result in a diversified portfolio, but it runs the risk of both accounts being invested in the same stocks or industry sectors. One would really have to look at the individual holdings of each fund to determine if the overall portfolio is well diversified. Another way to ensure proper diversification is to work with a financial planner who can look at your entire portfolio and help you balance your holdings.
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