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What's the better answer?
You have a $10,000 budget to spend on dessert for a dinner party your city is throwing for the first family of Mars. You've heard they're picky eaters. You would:
- Spend the $10,000 on a very large chocolate-banana-coconut-raspberry-almond-rum cake – your favorite.
- Spend the $10,000 on a variety of fancy cakes, custards, pies and ice cream flavors – and some salty snack treats, just in case.
The better answer is 2. The first choice is really risky, because you're spending all your money on something that might pay off big, but probably won't. With the second choice, you're spreading your risk among many options, so you'll probably have something for everyone you're trying to impress.
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Diversification is spreading your money around in different investments to spread the risk – like hedging a bet. The second dessert-buying strategy above is an example of how you can spread the risk by spreading your money around. But there's more to diversification:
- Diversification should start with asset classes: stocks, bonds, cash and inflation-protected securities.
- Diversification is also a test of how well an investment fund is being run. Investing in only a few stocks (50 or less) or a limited number of industries is risky.
- Diversifying your assets does not mean owning lots of investment funds. For instance, many stock investment funds actually own the same stocks. If you invest in similar funds, you may not get any protection against market declines and may end up paying higher costs.
As the word "diversification" implies, the investments should be "diverse" – or different. You may have heard of the "dot-com" Internet investing craze, for example. A lot of people invested in high-technology mutual funds that had doubled investors' money over the previous year. These people thought they were getting great investments that were "diversified" among different technology companies. However, because their investments were all in the same industry, many investors lost a lot of money when the whole industry went through its recent downturn. Their investments weren't really diversified – and they probably paid high fees to get into "hot" investments.
Remember, understanding diversification is just a start. The MyFRS Financial Guidance Program will guide you to the funds that provide the best diversification for your situation.
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