By Tosha Dunn, Spring 2016 Student Intern
Now let’s move along to a term that I have been sort of dancing around: diversification. This is definitely a term that you may, or may not, hear but one that should be in your mind, even if it isn’t in your adviser’s mind. Simply, diversification is investing in a true portfolio, so your investments aren’t concentrated in a single industry or a single market. Instead, you have a portfolio that represents industries that balance one another out, meaning that if one goes down, the other goes up. The goal is mitigating losses.
If you have a properly diversified portfolio, you may have a certain percentage of money that is invested in risky stock, but you may balance that risk against the investment in an index fund (index funds are meant to return whatever the market returns are from an index, like the S&P 500, so the investments are pegged in a way to a stable market; there’s no promise of 100% returns). And an index fund isn’t the only option, again, the goal is to create a portfolio with industries and risks that counterbalance one another. You want to have a wave pattern where if one wave peaks, the other is at a trough, that way, you are receiving a steady flow of returns. Of course, that is assuming you invest in only two financial vehicles, but you get the idea–balance.
Diversification comes from the idea of Modern Portfolio Theory, which you can investigate to your heart’s content at: http://pages.stern.nyu.edu/~eelton/papers/97-dec.pdf, http://post.nyssa.org/nyssa-news/2011/12/harry-markowitz-father-of-modern-portfolio-theory-still-diversified.html, and http://money.usnews.com/money/blogs/on-retirement/2012/12/13/why-i-am-clinging-to-failed-investment-strategies.
All of these articles delve into different levels of detail regarding the theory and its future, but hey, the guy who came up with it was a Nobel Prize Winning Economist, so there may be something to it.