If you’re a novice to investing, mutual funds and 401(k) accounts, you may be confused by some of the terminology. Diversification is one of the more misunderstood terms. In basic terms, diversification means investing in a variety of different assets so that if one drops, the whole portfolio won’t plummet. But it doesn’t always work that way, depending upon market forces. Here are some of the most common myths about diversification, designed to help give the neophyte investor a better understanding.
Myths about diversification No. 1 – Owning many mutual funds
When you sign up for a 401(k) plan through your employer, you have the option of choosing from as many as a dozen different mutual funds. The vague notion of diversification sets in, and the inexperienced investor splits contributions equally between all of the available choices. This doesn’t necessarily work, however, as the mutual funds can be very similar. In order to diversify and prime your portfolio for more lucrative return, you have to read into each one to get a wide range. To see just how diversified your portfolio is, tools like Morningstar’s Instant X-ray analyzes what you own and shows you pie charts.
Myths about diversification No. 2 – Diversification is for dummies
While some people have kept their money in cash and struck at the precise moment that a great investment opportunity has appeared, the vast majority of investors don’t have that kind of serendipitous timing. A diversified portfolio acts as a kind of safety net for those of us who can’t afford to bet millions of cash and liquid assets on a hunch. Spreading the wealth in tech stocks, energy companies, commodities and service companies allow you to never strike out financially, but as CFP Carl Richards notes, you also won’t be likely to hit the big home run.
Myths about diversification No. 3 – Total immunity to crashes
Just because you’ve taken the safe route with diversification doesn’t mean that you will be immune to stock market crashes. The only way to do that is not to invest. By investing in some high-quality bonds from the U.S. Treasury or a highly rated corporate or municipal bonds, your diversification hedges against fluctuations in the market. Just keep in mind that other investors will be doing this too in times of trouble, which drives up the price. Invest in such bonds while the market is hot.