Diversification a crucial point. That’s why it’s important to learn why you must diversify your portfolio if you want to protect your investments and grow your wealth.
Millions of people lose money in the stock market every year because they don’t understand one simple concept: diversification. We’re going to break down exactly what diversification is and why it’s so important for investors. We’ll help you become a lot smarter about protecting your money.
If you’ve been involved in the investment world for a time, you’ve likely heard the phrase “don’t put all your eggs in one basket” or, conversely, “throw all your eggs in one basket and watch it burst.” Intelligent investors reject risk the first camp contends it is prudent to buy stocks on the stock market.
Many companies, because it reduces portfolio risk; if a disaster strikes one of your companies, you still have the others. The second group believes that if you own too many companies, you don’t understand any of them very well, which is also risky. I’m here to tell you that these two groups frequently miss an important point and are both wrong.
According to the Bureau of Labor Statistics, you are currently making approximately $50,000 per year. Let’s assume that you will continue to work until age 70. Now, let’s assume that your salary will increase as it has for the past four decades.
Which is roughly 3.5 percent per year in nominal terms, and your salary will increase slightly beyond that as you gain experience. This means that you’ll earn $5, 2 million over the course of your lifetime. Not bad. Now we’re getting closer to where your income is an asset, and a pretty damn large one at that.
Possibly not a surprise, but bear with me what implications do you think this has on the conventional advice about diversification? We’re not quite done with the assumptions. Let’s say that you live in North Carolina, so your take-home pay is $47,000 per year and so after taxes, you earn approximately $4,800,000 over your lifetime. As investors, we know that a bird in the hand is worth more than a bird in the bush.
Today’s Bush dollars are more precious than tomorrow’s, so let’s apply a so-called 10 percent discount rate to all your future wage cash flows. This total may be referred to as the net present value of your future salary, which is $710,000. Now let me ask you, how much do you now have in savings?
According to the Fed’s 2019 survey of consumer finances, the median net worth of a household with members aged 35 and younger is approximately $14,000. Regardless of how you measure this, my guess is that your current savings and stock market investments represent a tiny portion of the net present value of your salary, which has interesting implications for your retirement planning.
Do not put all your eggs in one basket group says the one universal rule that idiots in finance know is diversification it’s the only free lunch you’ve got to diversify single stocks are a bad place to invest money you’re much better off being spread out and well-diversified.
Understand this, to put all your eggs in one basket and watch it group say diversification is for idiots. Diversification is for the amateur investor, not the professional. We believe diversification as practice makes very little sense for anyone who knows what they’re doing. However, regardless of which of these groups younger investors listen to, most of them remain undiversified.
As your current portfolio represents such a small portion of the total amount of money, you’ll earn over your lifetime, it doesn’t matter much for your risk profile whether you diversify or not. Which of these two looks riskier to you? The first represents an investor who purchased the S&P 500 index, while the second represents an investor who purchased only apple stock.
Not much of a distinction, right? In both cases, you’re still extremely dependent on your wage. This has two key implications for young investors. Initially, investing with limited resources should be focused on learning rather than risk exposure. If you lose all of your cash at age 25, for example, it probably won’t matter too much because you can replace it with your wage.
The conventional wisdom to invest in an S&P 500 index is actually terrible advice from this perspective because it yields virtually no experience with individual companies and industries. If you focus on learning instead, you’ll have experience under your belt when big money comes and your investing decisions carry a great deal of weight.
This is not the carrot but the stick approach to becoming a brilliant investor; most people’s learning experience is accelerated if it hurts.
Second, to reduce your financial risk, which is what diversification should do, you must shift your attention away from your portfolio and toward your earnings. Educating yourself to secure that income further is an effective way to reduce your risk, perhaps by creating additional income streams through a second job or entrepreneurial side hustle.
Keeping your mind and body healthy by exercising and eating well is also a great idea, but it has nothing to do with the structure of your portfolio. Based on this, we can conclude that diversification should be age-dependent. For example, a college student who is considering investing their first $2,000 does not need to diversify.
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