Your Diversification StrategyWhen investing a diversification strategy is the most successful approach to building wealth. The reason is simple. While buying Wal-Mart stock back in 1984 would have been like hitting the lottery if you waited long enough, few of us would have had the prescience to know that Wal-Mart would end up getting as large as it did. Picking individual stocks is simply pure luck. When you read or hear the pundits touting a given stock on the news, CNBC, or on the web, its probably best to ignore them. Think about this-there are thousands of stocks to choose from. Picking a big winner out of all those stocks gives you about 1 in 7,000 odds of getting wealth. It could happen, but its pure luck. Consider that back in the early 1980s, two other investments, Coca-Cola and Xerox, looked to be solid investments. Many investors at the time were probably more inclined to put there money there than with the upstart Wal-Mart. Had you chosen Coca-Cola, you would have done very well as the stock grew considerably over the next 20 years. Xerox? Well you would have been treading water. But who would have known that in 1979? So, investing in one or just a couple of stocks is just as likely to lead us down a road to nowhere if not ruin, as it is to make us rich. That's why a diversification strategy is important. While picking one or two stocks and hoping to hit the bigtime is pure luck, buying a group of stocks tilts the odds more in our favor. If you invest in 20 different stocks, odds are going to be that some will do badly, one or two will do really well, a few will do pretty well, and most will do fair. But with a diversified portfolio, stocks that lose a lot won't impact you as much as time goes on (of course they could turn around). In other words, suppose you had $10,000 in a really bad stock, and it lost $8,000 in value the first year. If that was part of a $200,000 portfolio where you had invested $10,000 each in 20 different companies, the loss would be disappointing but at year two that bad investment would only be $2,000 out of that same portfolio (which could have actually grown depending on what the other stocks did). So you can absorb the losses from your bad bet, and it may even come back as time goes on. That's all well and good, but who really has the time to research 20 different stocks, and to be honest, most of us aren't going to be all that good at picking the right stocks even doing the research. Indeed, many "predictions" by "analysts" turn out to be a bunch of hot air. Google the financial news and you'll see how analysts advised getting out of Ford just before it tripled in value. In any case, 20 stocks really isn't enough. What if you could invest in 100, 200, or even 500 companies? The record is clear. Those that do get a return on investment that's far better than what someone would get sinking all their cash into 15 stocks-most of the time. So your diversification strategy should be to be as diverse as possible. The problem is you would have to be Warren Buffet to be able to invest in 100 or more different companies. But fortunately, there are two successful investing tools available to just about anyone today: mutual funds and exchange traded funds. A mutual fund is basically a large pool of money collected from thousands of different investors. That money is then used to invest in securities on behalf of the investors. If you're serious about growing wealth and have the patience required to do so, mutual funds can be a vital link in your diversification strategy. For example, you can buy into a mutual fund that invests in the S & P 500. Now that's instant diversity. One investment for you, but you effectively are putting your money into 500 different stocks. One downside of mutual funds is that they require minimum initial investments that can be in the range of a few thousand dollars. Exchange traded funds or ETFs as they are called, are a relatively new (compared to mutual funds) investment tool that is far more user friendly. They are more compelling because they trade like stocks on exchanges, but give you all the advantages of mutual funds. So you can buy shares of an ETF that has the S & P 500 as its benchmark, or the Russell 2000, or just about anything you can name in the investment world. Since an ETF is a stock, it trades on the NYSE or other exchanges, and you can invest in as little as a single share. All you need is a brokerage account. Costs are lower than for actively managed mutual funds, and you can even invest in foreign markets, precious metals, and commodities. So I'd rank investing in exchange traded funds as step 1 of a diversification strategy. From there, make a pie chart of where you want to put your investments. For instance your pie chart could be split among domestic US large-cap stocks, emerging market stocks (China), gold, and real estate. It so happens you can invest in exchange traded funds in each case, so the next step would be picking your funds and buying shares. Mutual funds or exchange traded funds can also be used to invest in given market sectors, like energy, technology, or healthcare stocks. Some investors will want to have investing in different market sectors as part of their diversification strategy. You can also invest in bonds of different types, from Treasury bonds to high yield junk bonds. No matter which path you choose, a diversification strategy- no matter what it is really - is going to lead to more successful wealth building than buying individual stocks.
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