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Finance For Dummies

Finance For Dummies offers personal finance information on investing, retirement investing, finance, insurance, credit cards, loans and more. Personal finance education is our goal.

Saturday, April 22, 2006

One word on Investing . . . DIVERSIFICATION

Whether you are just starting investing or you have been doing it a long time you need to know one thing: YOU MUST DIVERSIFY YOUR INVESTMENTS!

What does this mean? Diversifying your investments means that you should not put all your eggs in one basket.

For example, you have come into $5,000 and never invested before. You get a great stock tip from a broker-friend-of-yours. While it is true that you could make some quick money with that investment and that can work fine. However, if you know for sure you do not want to lose a large percentage of that money in one fell swoop you would never put all your money in one stock.

If you really want to buy this stock you have been tipped on then maybe you put $1,000 of your windfall into that speculative stock. In addition to that you could buy four other stocks at $1,000 each that are different types of stocks. WHAT DOES THAT MEAN?
It means that you could buy stocks that are in different assest classes or different industry sectors.

  1. Your speculative stock is a microcap technology stock(meaning it is a very small company with a large possiblility of making money and an equal risk of losing that money).
  2. Then you pick a stock like GE. General Electric is a conglomerate, which means it is a company that makes its money from many different avenues. Also, GE is a large cap stock, meaning that is a very large company that has less of a risk than a micro-cap stock, but it also does not have the perpensity to bring large gains quickly.
  3. Your third company is a local bank that is a mid-cap (Its capitalization puts it in between a large-cap and small cap stock). You like the bank and you know a lot about it because it is local.
  4. Next, you watch some investing shows and you hear about a small-cap stock (In between mid-cap and micro-cap) that is in the healthcare industry. You know that it has more risk than a mid-cap stock, but its growth potential is more than a mid-cap.
  5. Lastly, you have some friends that live in foreign countries and you become exposed to some of the companies that reside outside the U.S.A. You decide that there is a utility company in South Korea that really interests you.
So let's check out you new portfolio. You have a large cap stock, mid-cap stock, small-cap stock, micro-cap and international stock. You have exposure in a conglomerate stock, technology stock, healthcare stock, financial stock and a utility. You might think that this is very risky, but by being exposed to all these different asset classes and industry sectors you have actually lowered your risk and increased your potential for long-term gains.

Diversification is the key to having a smoother ride in the stock market and not a bumpy one that seems like a rollercoaster.


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