3 Things Beginning Investors Get Painfully Wrong About Diversification

Diversification is one of the cornerstones of smart investing. Spreading your money around reduces your risk of loss, and it’s absolutely crucial when you’re talking about your life savings.

But diversification can be more complicated than a lot of people realize. If you’re new to investing, here are three things to keep in mind when deciding where to stash your cash.

1. Investing in different companies isn’t enough

It’s tempting to invest your savings in a handful of tech giants and call it a day, but this can actually be a really dangerous investing strategy. You’ll do great when the tech industry is doing well, but if a regulatory change or some other unforeseen circumstance hits tech companies, your portfolio could plunge, even if you have your money spread between a handful of different stocks.

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You need to keep your money in a few different sectors if you really want to reduce your risk of loss. It’s possible you could still see some of your investments dip during a market crash, but you’ll be in a better position to recover from them because you won’t be so dependent on the performance of a single industry.

2. Index funds might not diversify your money enough

An index fund is a great place for beginners to start when diversifying their money, but it might not always be enough on its own. These funds are bundles of dozens of stocks, and they’re designed to mimic the performance of a market index. Not only are they pretty easy to invest in, but they’re also one of the most affordable investments out there.

But if you’re only investing in an S&P 500 index fund, for example, your money is all in stocks — specifically, the stocks of large, U.S.-based companies. If the U.S. economy is hurting, you’ll probably still experience some heavy losses.

To be safe, you should keep some of your money in foreign stocks and in bonds to help balance out your portfolio.

3. It’s possible to be too diversified

Diversification reduces your portfolio’s volatility, but it can also reduce your returns. While there isn’t a clear tipping point as to how much diversification is too much, at some point, the minuscule reduction in risk you get from investing in yet another stock isn’t worth it.

You don’t need to invest in 1,000 stocks in order to be properly diversified — and you probably shouldn’t do that anyway. Most people don’t have time to research that many companies, and it can be easy to lose track of what you already have when your money is that spread out. Ideally, you want your money in at least 25 different companies, but you don’t need to go overboard.

If you’re investing in index funds, make sure you look into which stocks make up the index fund so you don’t end up with too much overlap. Try to choose funds that are composed of different stocks, and make sure you have a good mix of sectors as well.

Everyone’s investment portfolio is unique, but these principles hold true for everyone. Take time to look over your investment portfolio now and buy or sell as necessary until you’ve achieved a diversified portfolio. Don’t forget to rebalance your portfolio periodically as well to make sure that you stay appropriately diversified over time.

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