Written By: Alexandra Bartsch, intern
Say you were presented with three investment opportunities: One was expected to return 2%, another was expected to return 7%, and the last was expected to return 10%. Would you simply put all of your money into the investment that was expected to return 10%? Probably not. In order to expect higher returns on your investments, you will have to take on additional risk. Therefore, since the average investor is risk-adverse, they may spread their money out and invest a portion of it in each of these opportunities. This is the concept of diversification.
So how does diversification work? Pretend that you have a portfolio in which you invested all of your money in one stock, GM. Now say that a news story hits about a manufacturing defect in one of GM’s cars and its stock price drops 3%. Your entire portfolio has now lost 3% of its value. Now pretend that you have a portfolio in which you invested half of your money in GM and half in risk-free T-bills, and now that same news story hits. This time, you’ve only lost 1.5% of your portfolio’s value. Although a simplified version, this is the general idea behind diversification.
Allocating your assets among various asset classes, and to various investments within those different asset classes, can dramatically decrease risks related to firm-specific factors as well as to general economic conditions. At Yardley Wealth Management, we sit down with clients and determine which diversification strategy best fits their needs and risk tolerance and allocate their assets accordingly.