Investing Basics: Diversification For Dummies

Surely you remember the “Dummies” series of self-help books. They had bright yellow-and-black covers and offered to explain complex ideas in simple terms. “A reference for the rest of us!” was the slogan on every book.

It’s a powerful message, one that led the series to bestseller status many times over. Planetary physics, business accounting, orchid cultivation for profit — no subject was too technical for their writers to tackle and bring down to ordinary human terms.

I mention the Dummies books because one of the principle concepts of retirement investing, diversification, is often misunderstood by the very people who need most to understand it. So let’s “dummify” diversification.

A lot of investors think diversification is owning a lot of stocks, and that’s not wrong on the face of it. But let’s start with a simpler metaphor: Don’t put all your eggs in one basket.

If you invest in a single stock, or even 20 stocks that are similar, you have put all of your eggs in one basket. For instance, owning most or all of your retirement investments in stock at the company where you work is definitely the opposite of diversification.

Selling those company shares and buying other stocks helps, but not if you just buy five or six of your company’s close competitors. You might feel better about owning stock in an industry you understand, but you’re still investing in one small, industry-focused basket.

Spreading your money out over a lot of companies from a lot of different economic sectors is starting to diversify. It’s also expensive. The way to get diversification on the cheap is to buy an index fund that tracks an entire index, say the S&P 500 Index.

Feeling pretty good about your basket? Well, you are diversified in the sense that you no longer have all of your money on one stock or even one sector, but you are in one asset class — large company stocks.

You should now add small-cap stocks and get even more diversification by owning a bond index fund, then add foreign stocks and foreign bonds, again with broad index products. Add in some real estate and now you’re getting close to a portfolio that actually is broadly diversified.

Dumb no more

Any one of those companies could collapse and your portfolio won’t founder. Any one of those thousands of bonds can default and it won’t matter. If the stock market declines, the other asset classes often rise as investors move money out of stocks.

Rebalancing allows you to passively capture such market movements at a low cost without having to get into the high-risk business of predicting the future. Indexing keeps costs low. And your eggs are definitely in a large number of very different baskets.

Feeling a little less dumb? Next time an advisor or investor friend starts talking about “diversification,” all you need to do is remember eggs and baskets. It really isn’t any more complicated than that.

Advisors like to toss around diversification math terms to build mystique about what they do (and charge you more for their work), but diversification is just lowering risk by spreading money out over a lot of different investments.

Anyone can do it, even an investing “dummy.”