This is part eleven in a series that will occupy the “money hacks” slot at Get Rich Slowly during April, which is National Financial Literacy Month.

The next video in Michael Fischer’s series on Saving and Investing is about mutual funds. However, I think it would useful to have an introduction to diversification first, so I’ve bumped that video ahead in the lineup. Here’s Michael’s explanation of this important concept:


Diversification (4:35)

In his book, Saving and Investing, Michael spends a chapter explaining diversification. He writes:

Diversification means not putting all of our eggs into one basket. Research has shown that when we invest in multiple things that do not move perfectly together, that the risk/reward relationship can be improved. This is relevant when we buy more than one stock, multiple bonds, a mixture of stocks and bonds or a mixture of stocks, bonds, and commodities. The less assets move together, the better the diversification effect.

[...]

For the S&P 500 between 1939 and 2005, the average return including dividends was about 12.5%, [but] the annual returns move[d] around quite a bit. Risk-free government bonds have historically offered a low return, but the return has been less volatile. Neither investment has necessarily been ‘better’ — one has had a higher risk and higher return, the other one a lower risk and lower return — there is a trade-off.

When different assets are mixed together, the diversification provides an “evening” effect. Returns normalize, and so does risk. (Risk is, essentially, a measure of standard deviation, or fluctuation.)

The Bogleheads’ Guide to Investing also includes a chapter on diversification. The authors recommend diversifying stock market investments through the use of mutual funds, particularly index funds. (As we’ll see tomorrow, mutual funds are groups of stocks. By purchasing a group of stocks in this manner, we’re able to diversify.) But they recommend further diversifying by using mutual funds to invest in bonds and in foreign stock markets.

The U.S. Government Securities and Exchange Commission has a beginners’ guide to asset allocation, diversification, and rebalancing. This is an excellent article.

Michael Fischer spent nine years at Goldman Sachs, advising some of the largest private banks, mutual fund companies and hedge funds in the world on investment choices. Look for more episodes of Saving and Investing at Get Rich Slowly every weekday during the month of April. For more information, visit Michael’s site, Saving and Investing, or purchase his book.