Diversification: The Key to Your Investment Success from Great-Messages.com

Diversification: The Key to Your Investment Success
(From the book "The Truth About Money")

Am I saying all your money should be in stocks or stock funds?

Of course not. Nobody should subject all their money to just one risk

While it's easy to understand why people don't like risk, in truth there's nothing wrong with placing your money at risk; in fact, it's impossible not to, for even bank accounts place you at risk, if only due to taxes and inflation. Thus, every investment choice involves risk. The key, then, is knowing which risks are appropriate.

Most people are willing to gamble small amounts of money, as the popularity of lottery tickets, casinos, and football pools attests. Gamblers know they can't earn big money unless they're willing to take big risks. The secret, then, is to learn how to take risks properly.

So let's learn how to do that. Say you have $25,000 to invest for 25 years. If you choose a 5.25% CD, your account would grow to $96,621 (ignoring taxes).

On the other hand, lets say you split your $25,000 evenly into five piles as follows:

With the first pile, you buy 5,000 lottery tickets, and like almost everyone else who plays the lottery, you lose it all. Thus, after 25 years, the ending value of this $5,000 is zero.
With the second pile, you bury it all under your mattress. Thus, by earning no interest for 25 years, this $5,000 remains $5,000.
With the third pile, you open a bank savings account at 2% interest, where it grows to $8,240 over the next 25 years.

With the fourth pile, you buy a U.S. Treasury earning 7%. This pile grows to $28,627.

And with the fifth pile, you invest in the stock market, and although the average stock fund earned over 14.5% over the past 10 years , we'll say yours performed below average, earning only 12% per year. At that rate, your $5,000 will grow to $98,942.

In total, you have $140,809 - $44,188 more than if you had invested the entire amount in a CD - even though you lost all of the first pile, earned nothing on the second, invested in bank accounts with the third, super-safe government bonds with the fourth, and "gambled" in the stock market only with the last fifth.