If You Don't Know What You're Doing, Diversify!

Investing Tip #9

In the words of famed economist John Maynard Keynes, diversification is insurance against ignorance. He believed that risk could actually be reduced by holding fewer investments and getting to know them extraordinarily well. Of course, the man was one of the most brilliant financial minds of the past century so this philosophy isn’t sound policy for most investors – especially if they can’t analyze financial statements or don’t know the difference between the Dow Jones and a Dodo.

These days, widespread diversification can be had at a fraction of the cost of what was possible even a few decades ago. With index funds, mutual funds, and dividend reinvestment programs, the frictional expenses of owning shares in hundreds of different companies have largely been eliminated. This can help protect you against permanent loss by spreading your assets out over enough companies that if one, or even a few, of them go belly-up, you won’t be harmed.

One thing you want to watch for is correlation. It’s not enough to simply own 30 different stocks. If half of them consisted of Bank of America, JP Morgan Chase, Wells Fargo, U.S. Bank, Fifth Third Bancorp, etc., you may own a lot of shares in a lot of companies but you are not diversified! A systematic shock such as massive real estate loan failure could send shockwaves through the banking system, effectively hurting all of your positions.