Diversification:

Diversification isn't just about safety.. It's not even all about keeping your eggs in different baskets.

Suppose I offered you two investment options from which to choose: A bank CD earning 5% or a stock portfolio earning 3.5%. Which would you choose if these were your only choices?

You'd choose the bank CD. That's what. And you'd be wrong. Wrong I tell you! See if you can follow my logic here. Yes, In the first year you will make more money with the bank CD. But what happens after 10 years? Or 20? Even 30? (God forbid we should look any further than that!)

Here's what happens. The losing stocks keep losing and the winning stocks keep right on winning, more or less.

Say the stock portfolio looked like this (to keep it simple) and each company kept on compounding at the following rates:

Anyhoo Corp: -10.5%
Acme Widgets: -10%
Worker's Nightmare Co: +9%
Third World Sweat Inc: +15%

Let's also say that you put 10 grand into each stock in the beginning, say 10 years ago. What would the portfolio look like today? The losing stocks would be worth a lot less than $10,000, and the winning stocks would be worth a lot more. So what does that mean?

It means that originally the stock portfolio was pulling down 3.5% because you put equal amounts into each stock. Now it's making a much better return because the losers still lose 10%, but they are worth less overall.

For example, Anyhoo Corp would be worth about $3600 after 10 years of losing 10%. The first year it lost $1000 (10% of $10,000). This year it will only lose about $360 (Still 10%) ...and the winners will do just the opposite.

Third World would be worth about $44,000 in 10 years, and another 15% gain on that would kick it up another $6600. So by the end of 10 years, you'd have about $75,000 in the stock portfolio that was originally earning 3.5%, but is now through the hidden magic of diversification earning 13%.

The bank CD would still be earning 5%, and it would only be worth about $65,000. In 20 years the difference would be even larger. You get the idea. This is just a theoretical excercise. In real life stocks fluctuate in return and typically people are advised to re-balance their portfolios every so often.

Diversification not only helps you keep your money safer, but it helps it grow faster too. So the next time someone tells you diversification is for the chicken hearted, you can tell 'em it's not just about safety... it's for real men too.