Investing – Diversity to Reduce Risks

    Published: 06-16-2009
    Views: 3,536
    Financial Advisor Ric Edelman discusses the top four steps to successful investing including how to diversify to reduce risks.

    Ric Edelman: Every investment has risks, bank CDs are subject to inflation risk and tax risk; bonds face interest rate risk and credit risk; and stocks of course are sensitive to market risk. Every investment has risks, there is no way to avoid it, and that's why achieving your investment goals means limiting your exposure to each type of risk, and the best way to do that, is to diversify your investments.

    Imagine that you have $25,000 to invest for 25 years. If you choose a 3% CD for the whole amount, your account would grow to about $52,000.

    On the other hand, let's say that you split your $25,000 evenly into five piles of five grand each. With that first pile, you buy 5,000 lottery tickets, like everyone else you lose it all. With the second pile you are buried under your mattress. You have no interest for 25 years. The third pile of five grand, you open a bank account at 1% interest, and your five grand will go to about $6,400 over 25 years.

    With the fourth pile you buy a U.

    S. Treasury bond, it earns the same 3% as the bank CD and that five grand grows to about 10 grand, and with your fifth and last pile, you invest in the stock market. You are 8% per year, that's well below the 10% that the S&P 500 stock index has earned on average since 1926 according to Ibbotson Associates.

    At that rate, 10% a year your five grand will grow over 25 years to more than $34,000. In total you have about $3,800 more than if you had invested the entire amount in CDs. Even though you lost everything on the first pile, earned nothing on the second pile, invested in a bank account with a third and super-safe government bonds with the fourth, and you only gambled with the stock market with one-fifth of your money.

    This result is possible, thanks to diversification, it allows you to take small calculated risks, and even though some of your money, my fallen value or earned just a small amount, you only need one part of your money to earn above-average returns that can boost your overall portfolio.

    Surprisingly simple, yes, of course rather than invest in lottery tickets or mattresses, I recommended that you create a portfolio using up to 19 major asset classes in market sectors to help you achieve true diversification.