Diversification

Your ability to lower the risk you are taking with your assets begins with diversification. The old adage about having all your eggs in one basket becomes even more true when it is your nest egg.  It is unlikely that any of us will be completely correct in our outlook for various asset classes, specific funds or stocks or the direction of the overall economic forecast.  Acceptance of this leads us to understand that diversification is our only protection. The best way to diversify is to make sure that you have exposure to many asset classes and give yourself a range that you are willing to commit to those asset classes.  You can use a proactive asset allocation and shift the weight of those asset classes within reason or a static asset allocation that does not change.  Diversification also prevents us from falling in love with one asset class, which may lead to our financial demise if we get the timing wrong. 

Among the financially savvy, diversification is typically looked down upon as a simplistic tool for people who don't know what they are doing. This implies that if you do, you are too sophisticated for such a simple tactic.  Unless you have inside information about how an investment will play out, which is usually illegal, or you have a crystal ball, not utilizing diversification exposes you to much more extreme highs and of course lows.  It is one thing to have all of your eggs in one basket when it is your own company and you have significant control in the outcome.  If; as is usually the case, you are an outside investor then you are taking a significant gamble by placing too much of your wealth in one company or one asset class.  Plenty of extremely successful investors have thought that due to their previous success they are prescient enough to better determine their exposure to one company or asset.  This inevitably goes wrong for them if they do it often enough.  Remember the investor who had about $1billion in Bear Stearns when it collapsed, there was also the investor who had created a huge net worth but lost a significant portion of it by shorting VW stock.  Both of these folks thought well of their prowess as moneymen.  There are many examples.  If someone tells you that they are smart enough  that they do not need to diversify, it typically indicates that their "strategy" has not yet lost them significant value.  They may be talented investors, but they are creating more gains by taking significantly more risks and given the right situation that risk will translate into significant losses if not completely wipe them out.

While you are diversifying, keep in mind that you should not confuse money you will need in the next few years with investable assets.  If you know that you have an expense coming up, emergency fund dollars should be segregated into separate accounts that are highly liquid and in U.S. dollars.  This is the point that Jim Cramer was trying to make earlier in the year which has been frequently misread as a panicked cry to get out of equities all together.  His point is well taken as to a difficult market, but is also true in any market.  Many assets can trade in a very volatile range and you have to be prepared for losses if you invest money.

Please see the asset allocation article for a few examples of asset allocations an investor could implement based on their confidence in the economy.