I know you've heard it before. You need to diversify your investment assets. It's become such common advice among financial advisors that it's practically a mantra.
In fact, it's repeated so much that there's almost an expectation you should accept it and do it without even questioning it. Even if diversification is sound advice, you should know why so you can understand and believe it. For that matter, you need to know why so you can make your own informed decision.
I do believe that in most cases diversification is a good idea. I also think that you should know what diversification is, how it works, and what it can do for you. One of the biggest benefits is preserving wealth through diversification.
What Is Diversification?
I'll put this as basic as I can. If you want to look up detailed examples elsewhere online if you really want them. For now, I think you should know that your two choices when putting together a portfolio are concentration or diversification.
Concentration simply means that you put the majority of your assets into one class. Diversification means that you should spread out your assets over many different asset classes.
Using the concentration method can work well in two different scenarios, generally speaking. First, if you are younger, then you might have more time to take risks. Second, if you don't have much invested yet, then you want to grow your portfolio value as much as you can.
Growth concentrations usually emphasize the stock market. There are many kinds of stocks, but one category is known simply as growth stocks. These are usually shares for companies that are small or medium in size but display the right technical factors that would indicate they are about to grow in value at an extraordinary rate.
A regional chain of stores that's about to go national is a great example. They need capital in order to finance their growth, and stock sales are a way to do it. Their value explodes, which means your stock value grows exponentially.
Diversification means you don't concentrate everything on growth. If you only invest in stocks, then diversification might mean also holding value stocks, international stocks, and blue chip stocks. Diversification is even more powerful when you look outside the stock market and bonds and consider things such as real estate, commodities, precious metals, and cryptocurrencies.
The big benefit to diversification is that if one or two of your asset classes go down in value for a few quarters, they don't take your whole portfolio with them. Your wealth is generally preserved during the downturn. If other asset classes are actually growing, then you might even tread water or grow in value a bit.
How Does Diversification Work?
Diversification starts with spreading your investments around across various asset classes, but there's more to it than that. You need to choose asset classes you are comfortable with but also make sure they don't overlap. You also need to find the right balance, but that might change as you age.
If you're starting to save for retirement as an early adult, then you might want to go 80% in stocks and bonds so you take advantage of growth potential while you have time on your side. Put the other 20% primarily in real estate and 5% in precious metals. Just remember that I'm giving general advice and am no personal substitute for a professional financial planner.
As you get closer to retirement, your stock allocations should likely start shifting away from growth stocks and more towards blue-chip stocks that pay dividends and hold their value better. Look into bonds with good yields. Up your precious metals percentage from 5% up to 15%.
How Does Diversification Preserve Wealth?
Precious metals are a great example of how diversification preserves wealth. Should this surprise you as my example? Not on a gold and silver blog.
Let's assume you put 15% of your portfolio in your 50s or 60s into gold, silver, platinum, and palladium. Let's also assume that a market downturn strikes. Even in this age range, you're likely to see one or even two more recessions before you actually retire, and you don't want to see your portfolio wiped out.
You should always have some of your investments in growth stocks, at all ages. That asset class is going to get hit, though, and it will lose value. If it's only 25% of your portfolio, though, you won't be in as much danger.
High-yield bonds with good ratings are likely to hold their value. Blue-chip stocks pay dividends and represent companies so huge that they can weather a recession. Gold and silver work like hedges against inflation and might even grow in value.
If you practice quarterly rebalancing in your portfolio, then you might be used to taking gains from your growth assets and putting them into everything else. This time, you'll do the opposite and refill your growth assets. It's no different than planting seeds, and you'll be in a great position to harvest growth once it starts happening again.
I'm not going to tell you that you should diversify your portfolio because you already hear that everywhere else and all the time. What I will say is that you should know what diversification is, how it works, and how it works well for you. Preserving wealth is the biggest reason.
A properly diversified portfolio will have exposure to assets that grow at different rates. When the growth corner of your portfolio does well, you can move your gains into other assets that aren't as volatile. When your growth assets wind up plummeting in value, as they will do from time to time, your other assets will hold their ground.
I think the garden analogy might be the best way to look at it. If your garden only has one or two plants, then you're simply going to starve from time to time.