Diversification Explained

You could probably break a wooden pencil in two without much strain. However, it would take a lot of effort to break a bunch of pencils. Now, imagine that lone pencil is the technology stock category. If you were invested entirely in technology stocks, the market snapped that lone pencil a while ago. But what if, in addition to your tech stock pencil, you added to it a government bond pencil, a money market pencil, a precious metal pencil, a value investment pencil, a municipal bond investment pencil, and a few consumer stock pencils. Your tech stock pencil would bend, and perhaps still even break, but the band of pencils as a whole would remain strong and unbroken. Safety (and strength) in numbers—that's the power of diversification.

Why You Need to Diversify

Diversification is the spreading of investment risk by putting your assets in several categories of investments—stocks, bonds, money market instruments, precious metals, and the entire spectrum of mutual funds. Think of the 17,000 Enron employees who invested their 401(k)s heavily in the company's stock, only to helplessly watch it all evaporate before their eyes as the company collapsed into bankruptcy toward the end of 2001. Those employees believed in their company, in themselves, and, not surprisingly, in their company's stock.

Protect Yourself

Diversification protects you. It spreads your risk by putting your assets in several different categories of investments. The theory is that when one group goes down, not all of them go down; some may even go up. You protect your savings; you protect yourself. If those Enron employees had diversified their 401(k)s (no more than 10 percent invested in any one asset class, especially company stock), they would have possibly lost only a small portion of their retirement portfolio—instead of the whole thing. They would still possibly be able to make up those lost dollars—and still retire. They would still have a working foundation to continue to build from. They wouldn't have to start over again.