8/13/07
Contact:
Patricia Swanson, Human Development and Family Studies, (515) 294-2731,
pswanson@iastate.edu
Diversification
Risk is inevitable with investing, but diversification can help reduce some of this risk.
“Two adages accurately sum up diversification – don’t put all your eggs in one basket
and there’s safety in numbers, ” according to Pat Swanson, CFP® and families specialist
with Iowa State University (ISU) Extension’s Invest Wisely Project
(www.extension.iastate.edu/investwisely).
Swanson cites the recent example of many Enron employees who put all their retirement
“eggs” in Enron stock, ignoring both adages. When Enron went into bankruptcy, their
retirement funds were wiped out.
And according to Craig Goettsch, director of Investor Education for the Iowa Insurance
Division, “One of the most common mistakes I’ve seen as a securities regulator is the
failure to diversity. A high percentage of persons we surveyed don’t grasp the need to
spread their risk.”
The goal of diversification is to put your money in various investments so that if one
investment loses money, the other investments may make up for those losses.
“Investing in one security, as many Enron employees did with their retirement funds, can
result in disaster,” Swanson says. “But if you invest in several different securities, the
impact of any one investment on the portfolio’s return is not that significant, even if that
security’s value goes to zero.”
For example, Swanson explains, in a portfolio that includes equal amounts invested in 15
stocks, if one stock becomes worthless and the other 14 stocks in the portfolio average a
12 percent return, then the portfolio’s return would be 11.2 percent. “So, there is safety
in numbers.”
And you should diversify your investments both by selecting a variety of asset classes,
such as stocks and bonds, and a variety of securities within one asset class. Have some of
your investment dollars in a mix of cash, stocks, bonds, and possibly other asset
categories and then also diversify within each of these categories.
“You are not diversified if your portfolio consists of stock in one or two companies or in
companies in the same sector of the economy,” Swanson says. Different industries, such
as oil firms and retail firms, may act differently to changing economic conditions. For
example, when oil prices increase, oil firms benefit but retailers may lose business
because consumers have less money to spend after filling their gas tanks.
Likewise, fixed-income investments are not diversified if you have only municipal bonds.
“Fixed-income investments should include both government and corporate bonds and
possibly some international exposure by having bonds in companies that operate in other
countries” Swanson says.
To adequately diversify with individual stocks and bonds, you need enough money to
select a variety of investments. Mutual funds are a way for even the small investor to
become diversified. A mutual fund pools dollars from many investors and assembles a
portfolio designed to achieve a specific investment objective (e.g., growth). “If you
wisely pick the right funds you can take a small amount of money and get diversified via
mutual funds,” For example, select a mutual fund that invests in both stocks and bonds.
Swanson says that time period is another type of diversification that is often overlooked.
“The inclination is to “time” buying and selling but this is very difficult, if not
impossible, to do. It is easier to be invested for a longer period of time over different
market cycles. Although there may be fluctuations over the short term when investing in
stocks (for example, stocks lost 22 percent in 2002 but were up 29 percent the next year),
by being invested over a longer period of time, these fluctuations can be smoothed out.
“Done properly, diversification can reduce much of the total risk of investing. Even with
a relatively small amount of money, all investors should diversify their investments,
whatever their goals. Diversification is a cornerstone of wise investing,” Swanson
concludes.
The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web
resources for investors. It is funded by a grant from the Investor Protection Trust (IPT).
The IPT is a nonprofit organization devoted to investor education. Since 1993 the IPT
has worked with the States to provide the independent, objective investor education
needed by all Americans to make informed investment decisions.
www.investorprotection.org.
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