Editor’s note: This article was first published in December 2010. The remark that stocks and gold had not moved in opposite directions in recent years refers to the period around the 2008 financial crisis.
From some of the questions I’ve received, I’ve realised that either I didn’t explain myself well on how to diversify when investing, or I was misunderstood, bearing in mind that the article was aimed at people who are just getting started with investing.
As a general rule, there are two types of investors. There’s the one who follows Robert Kiyosaki’s approach, who was an enemy of diversification, and there’s the one who tries to protect himself to some extent by reducing losses with a diversified portfolio. Both approaches are valid, but if you decide to diversify, you need to know how to do it properly.
When we talk about diversifying your investments, it doesn’t mean (as some people have understood) investing all your capital in 8 or 10 stocks, because that isn’t really diversifying. You’re “betting” everything on the same investment vehicle, and in that case the Ibex 35 (the main Spanish stock index) can go for you or against you, affecting every stock at once.
Diversifying means building your investment portfolio across different investment vehicles and ways of investing. You can diversify by putting 50% into fixed income and 50% into equities, and you can also invest part of your portfolio in foreign debt from emerging countries, foreign stock markets, fixed-term deposits and even (although I’m not a fan) investment funds.
The problems with diversifying: The biggest problem you run into when you diversify across a multitude of investment vehicles and securities is keeping control and tracking them all, which becomes very difficult. In fact, many expert investors struggle to properly follow even 8 stocks.
See also: In the end, the most profitable stocks were the ones recommended to conservative investors
On other occasions, people make the mistake of investing in opposing products, where if one rises, the other falls. Some see this as a way of making sure they won’t lose money, but the reality is that it leads to a technical “draw” between losses and gains.
Imagine for a moment that you put 50% into the stock market and the other 50% into gold. It has always been said that when the stock market goes up, gold goes down, and when the stock market falls, gold rises, except for what we’ve lived through these past years. This kind of diversification would be like going to a bookmaker and betting on both Real Madrid and Barcelona in the same match. You make sure that whoever wins, you won’t lose money, but as the saying goes, what you gain on one side you lose on the other, and in the worst case the match could end in a draw.
So, to sum up, diversifying is good, but it’s even better to study a few specific stocks and take advantage of fixed-income opportunities. Above all, stay informed about both the market and the plans of the company you’re going to invest in: its expansion plans, future mergers or acquisitions, and so on.
And since nobody can predict how the stock market will behave, we should always have exit strategies that minimise losses through other investment vehicles.
Further reading
- Common mistakes when investing
- Serious mistakes investors make when investing
- How you can ruin yourself investing in the stock market
- How to invest in the US stock market
Featured image: United Soybean Board, CC BY 2.0, via Flickr.
