Strategy #2: Diversify
One of the most important strategies in investing is to diversify. That means to spread out your money across different investment areas.
If someone works for General Motors (GM), and they’re a proud GM employee, they may want to put their entire retirement plan into GM’s stock.
As you can see, this person will be in really big trouble if GM runs into any major issues. This person could lose their job, as well as their entire retirement savings all at the same time.
In order to prevent something like that from happening, you want to spread your investments out to different companies in different industries. If the price of oil goes up and you own car stocks, those will probably lose money. But if you own oil stock, those will make money back, so it all balances out.
Generally, investors want to look at building a portfolio that has a large mix of many different types of companies.
Consider these points about diversifying your investments:
- Risk versus reward. Always keep in mind diversifying is all about balancing potential risks and rewards. You want to make money, but also be protected from devastating losses.
- Spread the wealth. Diversifying isn’t about having a large number of investments. Instead, it’s about spreading your money around into different types of investments and accounts.
- For example, you might want to invest in some combination of stocks, bonds, real estate and international investments, as well as keeping some disposable income in cash.
- An old proverb. The concept of diversifying is based on the saying, “Don’t put all your eggs in one basket.”
- This translates to not putting all of your investments into one account in case “you drop that basket” or that investment crashes.
- Instead, you should spread out your “eggs,” or money, into different baskets, so you don’t lose everything with a poor investment.
- Do your research. In order to diversify correctly, you need to do your research. You should ask and be able to answer these questions:
- What kind of investments should I buy?
- How much money should I put into each different type of investment?
- How do I diversify within a particular investment category?
Taking the time to ask important questions could certainly be the difference between a diversified and non-diversified portfolio.
Diversifying With Index Funds
Index funds are a great, simple way to build a diversified portfolio. An index fund buys up all the companies on the market, trying to match it.
For example, let’s say you have the S&P 500, that’s 500 large cap companies in America. Instead of taking the time to invest in each of these companies yourself, you would invest in an index fund. Then a fund manager builds your portfolio of all those companies.
By doing this, you’ve built a very well-diversified portfolio with just one purchase. The fund manager uses the money from many small investors to put together this great portfolio. And, when you invest in it, you own a portion of each share in the portfolio.
The beauty of index funds is they generally have very, very low fees. You just buy them, hold them, and they’ll get you to your retirement goals in a slow and steady pace.
Considerations of Index Funds
The only issue with index funds is you’re just trading the market, so you’re going to be buying the good with the bad. You’re never going to be the best investor on the block, but you’re never going to be the worst.
Long term, that tends to be where you want to be. Those who have really, really great years tend to have very, very poor years later on.
The only other downside to index funds is they’re a little bit boring. But, when it comes to your retirement planning, it’s much better to be slow and steady than to roll the dice and risk it all.
In terms of reducing taxes on investments, the index funds are another way to go. Once you buy an index fund, you don’t pay taxes until you sell that fund.
If the manager inside that portfolio is trading stocks or changing the portfolio, it won’t greatly affect you. It’s not like you’re buying or selling different shares.
That’s the reason why using an index fund is a good way to reduce your taxes, as well as to keep a diversified portfolio.
“Taxes, after all, are dues that we pay for the privileges of membership in an organized society.”~Franklin Delano Roosevelt
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