Why Diversification Is So Important—and How to Get Started

“Tis the part of a wise man to keep himself today for tomorrow and not venture all his eggs in one basket.” That axiom appears in the Miguel de Cervantes tome “Don Quixote” in 1615.

The same eggs-in-one-basket concept could be applied to investing today, as inflation, recession, war and pandemic are all present. And no one, really, knows how hard or soft of a landing to expect, leaving us at least partially blind to which baskets deserve our eggs.

Knowing which baskets to choose is the key to diversification. And the art of where to put your eggs is called asset allocation. So, the key to being a smart, diversified investor is to identify your risk appetite, allocate your assets accordingly and pursue the maximum return possible. Here are three steps to enact this tried-and-true strategy.

When I started my career in Wall Street, I was fortunate to learn at a leading investment advisory and asset allocation service. We created personalized portfolios for our clients based on their goals, time horizon, age, knowledge and, most importantly, risk.

Risk is key when investing because we all love to win but some of us have a lower tolerance for losing.  (We make the same risk-tolerance judgment when deciding whether or not to get onto a roller coaster at an amusement park.) So, knowing what you will—and won’t—tolerate is important when choosing where to invest.

There are many choices for investing from low to high-risk: starting with cash and U.S treasury bonds being the least risky, and commodities and emerging markets as being the most risky. To my clients, I typically recommend a diversified portfolio that has the following asset categories:

• Equities: Large, small, international, emerging markets and special sectors

• Fixed: U.S., corporate and international bonds

Consult your financial investment advisor about the percentages of allocation, based on your risk tolerance. Then you can sleep better at night, knowing that the risk of losing all your eggs has been diminished.

There is a common chart that we use when presenting asset allocation to our clients and in my workshops, and we called it the quilt because it has many different colors representing each asset category by year going back at least 10 years. If you follow the “winner” across the timeline, you will notice that no asset class is consistently a winner, and this is because the economy constantly changes its cycle and asset categories are not correlated with each other.

Once you know this, you’ll be more motivated to invest in both asset categories—that increases your chances of making money. In mid-2022, for example, large companies were down, small companies were increasing in value, and it would behoove you to diversify your investment in the asset category. 

But how do you become an investment guru? Well, you don’t have to if you keep your portfolio diversified, according to the percentages your advisor suggests. It’s also recommended to see cash as an asset category. This way, you’ll have liquid assets to be nimble and take advantage of opportunities when other assets become attractive.

Tip

Remember, your investment portfolio should not represent 100% of your assets or net worth. You should have real estate property, a business and other money saved for your financial well being.

Rebalance, rebalance, rebalance: Once your investments are diversified, you might include a “net worth portfolio” to include other assets. This way, you will have a strategy for growth and can avoid overweighting an asset category and increasing your risk.

For example, let’s say you have a net worth of $750,000 and have distributed it equally into three categories: $250,000 to your house (real estate property), $250,000 to your retirement accounts and $250,000 to your business. Fast forward 10 years without rebalancing, and you might have $500,000 in your house, $300,000 for your retirement and $300,000 for your business. Your net worth portfolio is now clearly unbalanced, so you should aim to rebalance your assets, perhaps by selling from the “winners” (real estate) to give to the “losers” (retirement, business).

It’s healthy to always keep your assets diversified and aligned to the strategy that you choose for growth—and that you include assets beyond just investments.