Investing: Don't Scramble Your Eggs

Financial advisors have been preaching the use of portfolio diversification to reduce risk for years. Unfortunately, the way most do it leaves your portfolio vulnerable! Read on to find out how to properly diversify your portfolio.

We've all heard that it's not wise to put all of your eggs in one basket. For safety, we are told that it is better to divide our eggs among several baskets because if one gets dropped it isn't going to break all our eggs. Wall Street refers to this as diversification.

Many people think that if they own more than one investment that they are diversified. Others think that diversifying means that they should not keep all of their money with one institution or the same advisor. This isn't diversification.

The egg analogy doesn't accurately reflect the underlying reasons for diversification. There are many different risks we face. There is market risk, interest rate risk, credit risk and inflation risk, just to name a few. The purpose of diversification is to help you reduce your exposure to all of these risks, not just one or two of them.

There's no such thing as the Perfect Investment. EVERY investment has risks and rewards. Combining investments with different risks and rewards can result in the reward of one offsetting the risk of another.

Here's a simplified example. Many retirees recognize that there is greater risk of losing their principal when investing in the stock market then there is in a Certificate of Deposit (CD). As a result, many choose to avoid the stock market all together.

Neither CDs nor a stock market investment are perfect. The reward of CDs is their stability. But they aren't designed to protect you from inflation risk. A stock market-based investment is designed to protect you from inflation risk but it lacks the stability of the CD.

That's where diversification helps. Spreading your money among both CDs and stock market-based investments is a way to reduce the risks associated with each. Doing so reduces the overall risk of your portfolio and increases the probability that you will achieve your goals.

Spreading your portfolio between CDs and stocks won't adequately protect you from all the risks you face. Portfolios should be divided among cash, bonds, real-estate and equities, further sub-divided into different classes and then the classes into different investments. Many advisors do this but that's where they stop...and fail.

Most advisors fail to properly diversify a portfolio by strategy. If your entire portfolio is based on the same strategy then your entire portfolio is exposed to the risks associated with that strategy.

Probably 98 out of 100 advisors will tell you that the Buy and Hold strategy is the only successful way to invest in the stock market. Doing so puts YOU at risk. That's why so many investors suffered losses of 30-50% or more between 2000 and 2002. The problem wasn't the type of investment, the problem was the advisor failed to diversify your portfolio by strategy.

There are many different strategies available. I'm not sold out to any single strategy. Just like investments, each strategy has strengths and weaknesses. That's why I diversify clients between different types of investments AND different underlying strategies.

I'll use a Buy and Hold strategy, but I will offset its risks with a proprietary strategy designed to significantly reduce stock market losses. I use traditional investments but I also find other ways to meet my client's needs. I develop different strategies to meet different needs--diversifying along the way.

For instance, one of my high-income strategies uses a type of investment unfamiliar to most advisors (because they can't earn a commission on them). To reduce risk, it's diversified among 20 individual investments. Three of them lost money in 2005--one lost 29%! The other 17 more thn made up for that, though, with 7 having gains over 40% each. As good as this strategy is, I'll only use it for a portion of a portfolio.

Diversification can be used to reduce the specific risks your portfolio faces. Use different categories, classes and individual investments. And make sure that you use more than one strategy. Doing so will help you protect what you have and make it grow.