Wednesday, May 11, 2016

Investment Essentials: Diversification and Specialties

I have written about this many times in the blog before but I cannot state just how important diversification is and why it should also be taken with a grain of salt when you yourself have an expertise. Diversification, if you don't know, is the idea that you are better protected if you spread out your investments into many different areas. This could be diversification through different stocks, different sectors, or even different investments such as mutual funds, ETFs (exchange trade funds), or others.

Diversification is very important. Let's say for arguments sake that you have $100,000 and you've chosen to invest it all into General Electric (GE). Let's also say that I on the other hand invest $100,000 as well but I split mine into two different companies, General Electric and Kohls (KSS). I split the investments 50/50. I would therefore be more diversified than you. What happens then if a scandal hits General Electric (GE) and the stock takes a tumble. The share price of General Electric falls 50%. Due to the fact that you are less diversified, you would lose $50,000 while I would only lose $25,000. This is a simple example but it gets the point across. You almost never want to have all your eggs in one basket. Where it could very well pay off in the previous example if General Electric (GE) doubled in price due to good news, it is equally likely that they could get cut in half by bad news.

However, sometimes it is good to keep your money in the larger part in a few places that you may have a lot of information about. I myself have a very large understanding of consumer products due to my psychology degree and background in the marketing of products. Due to this, my portfolio is very weighted towards that sector. While this may seem like it is less diverse, it is still insulated because I made better selections in that area due to having more knowledge of that sector. More knowledge typically translates to better picks even if the sector gets hit. It's great to keep this in mind as a factor if you yourself have a specialty.

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