Diligently saving money for retirement is the first key to successfully saving up your nest egg. You can’t live off a nest egg if you never put any money into it, so get started today. After you get started, multiple points of view argue what the following most important step should be. Some think picking index mutual funds over actively managed funds is the most important. Others think you should maximize your contributions every year even if it means putting up with actively managed funds. Today we’ll make the case that after you get started, the next important step for your retirement is to diversify your investments.
What is Diversification?
There are complicated definitions of diversification available, but we prefer to keep things simple.
For our purposes, diversification is defined as the spreading out of your portfolio dollars into multiple investments and investment classes. You spread your risk of taking a huge hit by a drop in the stock market by spreading out where the money sits. You still ride the roller coaster that is investing in the market, but the ups aren’t as high as they could be, and the downs are not as low.
One Nest Egg, One Basket
Picking individual stocks is a dangerous game that is similar to playing Russian Roulette with your investment portfolio. If you put all of your portfolio into the “right” stocks, you could make a killing in the stock market. If you put your entire portfolio into one stock and it triples in value in one year, you’ve earned an amazing return. Likewise, picking the “wrong” stocks could cost you dearly — perhaps your entire portfolio. Putting 100% of your portfolio in one stock could mean the company goes out of business tomorrow — leaving you stock notes as worthless pieces of paper. Would you dare risk your entire portfolio in one, single investment such as an individual stock? If you are just getting started and have $500 toward your nest egg, you might. But $20,000? $200,000? $2 million? This is where diversification kicks in.
Multiple Eggs, Multiple Baskets
Instead of putting a single egg representing all your savings into one basket, you want multiple eggs and multiple baskets. If you have 9 baskets each holding 1 egg, and 2 of the baskets are ruined, you still have 7 to rely on. Put everything into one basket and drop it? Everything is ruined.
You want to hedge your bets and spread your portfolio out in asset classes: growth stocks and value stocks, small companies and large international organizations. Instead of 1 company holding your nest egg, you want 10. Better yet you want your funds spread over 100, 500, or 1,000 firms and the whole thing is managed by a mutual fund company whose entire purpose is to make themselves money by making your money grow.
How to Diversify?
Doing a thorough job of picking individual companies to invest in is complicated and time consuming. Picking 30 stocks really well takes a long time, and then tracking those companies after you make your selection is equally challenging. Thankfully, retail investors like you and I have another option: the mutual fund. You and thousands of other customers hand their funds over to a mutual fund company. The company takes the money and either through a portfolio algorithm or through human management decisions, decides what companies to invest those dollars in. You could be invested in just one mutual fund — which seems undiversified — but have your money really invested into the 500 companies that make up the S&P 500. In short, your bets are much better hedged in a mutual fund than by picking stocks on your own.
If you want to raise the bar and maintain a little bit more control, you could invest your funds in exchange traded mutual funds, or ETFs. These funds act like mutual funds where many people put their money to work in investing in a portfolio, but they are traded like stocks and carry low expense ratios. Most ETFs are focused on specific industries or investment styles. You could pick a total market bond ETF to cover the entire bond market, an S&P 500 ETF to get your core investment growth, and dedicate a smaller portion to overseas investments. You retain control, but increase your risk of making a poor fund or investment strategy.
No Amount of Saving Will Protect You From a Lack of Diversification
Why do we think diversification should come immediately after getting started in the hierarchy of the most important pieces to retirement success? It’s easy: you can’t recover if you lose 50% or more of your portfolio in a short period of time. A lack of diversification can do that to your nest egg. (Just ask someone you know whose undiversified portfolio got hit in the financial crisis and they’ve tried to retire since then. It’s impossible.) You can save for years and years to the point where you have millions of dollars, but if it is all sitting in one stock, you’re just waiting for something bad to happen. You can’t afford a risk like that, so diversify your funds in the beginning to develop this financial habit. It won’t seem to make much difference with a beginning account balance, but when you’ve got millions on the line you will be glad you learned how to diversify when you first got started.
This article is by Kevin Mulligan. He is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. Kevin’s been utilizing a Roth IRA to save for retirement since 2008.
Photo by Esthersita1 via Flickr