This blog is courtesy of Russ Thornton of Wealthcare for Women.
In investing, being well-diversified means always having to say I’m sorry.
That’s because, in a diversified portfolio of investments, some of your investment will almost always be down in value. At least relative to your other investments.
Of course, the hope is that at the same time, while some of your investments may be down, some of your investments will also be up in value.
This is the essence of diversifying your investments. Or not putting all your eggs in one basket.
If all your investments are going up in value at the same time, while it might feel good to watch your account balance grow, you’re not diversified. And everything won’t go up in value forever.
The same holds true if all your investments are doing down in value at the same time.
So you might be asking about now if I’m truly diversified in my investments will I ever make any money? Or will investments going up in value be offset by other investments going down in value?
This brings up the concept of correlation among investments.
Correlation is a statistical measure that calculates how closely the performance of one investment mirrors the performance of another investment.
If two investments have a perfect negative correlation, it means they move in opposite directions all the time.
If they have a perfect positive correlation, it means they move in the same direction all the time.
The more your investments approach perfect positive correlation, the less diversified they are. They will all be up or all be down because they all move in the same direction at all times.
But this isn’t a statistics class.
Just remember that you want to construct a portfolio that reduces the chance that all your investments move in the same direction at the same time.
And please note: even proper diversification isn’t perfect all the time. For an example, look at the markets in 2008 when pretty much all investments fell at the same time regardless of their correlation measures.
But more times than not, diversification works. Especially over long periods of time.
I believe the best financial strategies are those which are simultaneously simple and effective.
But simple and effective isn’t always easy. Just as it isn’t always easy to remain diversified when the broad market is going up.
And while diversification isn’t the only element of sound, long-term investing, but it’s certainly a key component. And one that I believe in and utilize with my clients as well as with my own investments.
But even if, like me, you believe in the benefits of diversification, there will be times where some of your portfolio will down in value.
That’s part of the bargain with diversification. But it’s a small price to pay in the short-term for what will hopefully be smoother, less erratic wealth building that stretches over decades into your future.
If fact, I take back my apology.
When it comes to diversification, I have nothing to apologize for.
However, if you’re not broadly diversified across your portfolio, you might wind up being the one who’s sorry.