Friday, November 21, 2008

Investment Diversification

In a recent blog entry, I emphasized the advantages of pursuing multiple musical income sources: higher total income, greater income stability, and increased networking opportunities.

The same principle applies to investing your hard-earned money. Maintaining a diversified investment portfolio basically means not putting all of your eggs into one basket. Remember when you told your parents that you wanted to be a musician, and their first reaction was to tell you to make sure you have another skill "to fall back on"? Well, I didn't like to hear it either, but looking back, I have to admit it was probably good advice.

In a similar way, betting most or all of your precious money on a single investment can be risky. If, for example, you choose to invest in stocks, most experts recommend holding stock of at least five to ten different companies to achieve reasonable diversification.

If you had invested all of your money in Lehman Brothers Holdings one year ago, you'd be broke right now because they went bankrupt in September. Few could have predicted that such a large firm, with a long and reputable history, would have been brought down so quickly. Even many highly trained and experienced professional investors regrettably invested in Lehman recently, so none of us are immune from making these kinds of mistakes.

If, on the other hand, you had invested half of your money in Lehman Brothers, and the other half in Star Scientific, Inc. (which has had a great year), you'd be roughly breaking even at this point. You would still be under-diversified, in my opinion, but this example illustrates the fact that even a little diversification is much safer than none at all.

As a small, individual investor with limited information, it can be hard to compete with the pros at picking good individual stocks or other investments. Perhaps even more importantly, brilliant artists like myself are too busy honing our creative genius (joke) to be bothered with monitoring the day-to-day performance of every stock and constantly worrying about timing our trades just right.

For people like us, there are mutual funds and ETFs. A detailed discussion of these investment vehicles is a subject for a future entry, but suffice it to say that they offer diversification in a simple package to the small time investor. Mutual funds and ETFs of the low cost index variety offer the ultimate in diversification.

If diversification is so great, why aren't all investors super diversified? The short answer is that they think they are smarter than the rest of us. If you are smart enough to only pick the winners and time every transaction ideally, then you can do better with an undiversified portfolio. Unfortunately, VERY FEW investors can pull this off with any consistency. Like, virtually nobody. Lots of people found this out the hard way recently when they tried sinking all of their money into real estate at the wrong time. They weren't diversified, and they bet on the wrong horse.

I'll be honest. Most types of assets have been losing value lately, so even diversified investors are getting burned. But just as a musician with multiple steady gigs can afford to lose one of those gigs, a well-diversified investor can avoid losing the whole enchilada when a few stocks go south.

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