It's an unpopular truth: Smart investors don't become millionaires overnight. They know that investing can grow wealth quickly, but it can also take it away just as fast if you don't follow some basic principles.
Beginning investors aren't always aware of these principles, and it can lead them to make some costly mistakes. Below, we'll look at one in particular that could wipe you out in one fell swoop: investing all of your money in a single stock.
What are you investing your money in?
If you guess right with an individual stock, it can look like a genius move. For example, if you'd invested $75,000 in AMC Entertainment Holdings stock a year ago and sold it on June 1, 2021, you'd have made over $1 million. Investment fees would eat into the profits a little, but no one can deny that's a great payday.
So why aren't more people sinking their savings into downtrodden stocks like these in the hopes of making a fortune? Probably because of what can come next.
If you'd held onto your AMC shares rather than selling on June 1, you'd have watched their value plummet to less than $725,000 in the next two months. That's still a large sum, but it's quite a bit less than what you would have had if you'd sold them earlier, and they could fall even lower in the future.
This phenomenon isn't just limited to meme stocks. Even the best stocks experience some ups and downs, particularly in recessions. This is problematic for investors, particularly older investors who are trying to protect the nest eggs they'll soon have to live off of.
How to make a fortune while protecting what you have
Diversification can help you avoid this issue. Investing your money in multiple stocks minimizes the effect that any one stock has on your portfolio. This means a single, fast-rising stock isn't going to turn you into an overnight millionaire, as could happen if you had all your savings invested in that stock. But it helps you better weather the lows. If one stock is doing poorly, hopefully you'll have another that's doing well to compensate for it.
Diversification isn't just about investing in more than one stock, though. You also need to spread your money around between multiple industries. The COVID-19 pandemic illustrated why this was necessary when a lot of travel-related companies suffered as a result of the nationwide lockdown. Keeping some money invested in multiple industries prevents something like this from devastating your portfolio.
You also need to keep some of your money in safer investments, like bonds, that don't see the wild fluctuations that stocks do. This is especially important as you get older when you're trying to protect what you have. But you don't want to make this move too soon. Bonds don't have the same earning potential as stocks, so moving your money out of stocks too quickly could slow your savings growth.
A good rule of thumb is to keep 110% minus your age in stocks. For example, a 50-year-old would want about 60% of their savings in stocks and 40% in bonds. Over time, you gradually shift more of your savings out of stocks and into bonds.
It all sounds more complicated than it actually is. You can quickly diversify your stocks by investing in a single index fund. These are bundles of hundreds of stocks you purchase together. For example, S&P 500 index funds contain the stocks of all 500 companies that appear in the S&P 500 index. They include companies in several different sectors.
If you keep the bulk of your savings in one of these, then all you need to do is balance it out with some bonds. You can also purchase bond funds — bundles of bonds — if you want, or you could purchase a few bonds individually. Purchasing individual stocks is also an option, but it's not necessary to successfully diversify your wealth.
Once you've built a diversified portfolio, it's a good idea to take a look at it at least once per year and rebalance it as necessary. Sometimes, certain high-performing stocks end up making up a larger proportion of your investments than you intended and that can put you at risk of loss. Staying aware of what's happening with your portfolio can help keep you on the right track.
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