While there will always be risk involved when you invest, you can eliminate a lot of the unnecessary risk if you understand these key concepts. Here’s some jargon demystified.
DIVERSIFICATION: Diversification is just a fancy way of saying, don’t put all of your eggs in one basket. If you invest in many companies in varying industries, countries and markets, your risk of all of them decreasing at the same time goes down tremendously. If you own equity in 100 companies and one of them has a fire in it’s manufacturing facility and can’t produce sales for a year, that will only negatively effect 1% of your investments. Not too shabby!
ALLOCATION: Your allocation is your mix of asset classes or stocks, bonds and cash. Why is this mix important? It’s a way to balance risk and diversify (remember diversification above?) because each asset class has different risk and rewards and typically perform differently in different markets. This protects investors from losing their entire portfolio if one asset category significantly drops or even loses all of its value.
Practically speaking, you can do this in a few ways. You can select many different stocks and bonds in different industries, markets and countries to diversify your investments yourself. OR, you can make it a whole lot easier on yourself and invest in a fund. A fund is just pooled money that gets invested a certain way. Using funds you can invest in hundreds of companies in different asset classes, countries, industries, and markets even if you only buy one share. How handy!
There are two types of funds generally –
PASSIVELY MANAGED: Passively managed funds are also called index funds because they mirror a certain market index (i.e. S&P 500, Dow Jones Industrial Average, Russell 3000, etc.). This means the money going into an index fund will be automatically invested proportionally into individual stocks or bonds according to the percentage they make of that specific index. The Vanguard 500 Fund for example mirrors the S&P index. When you invest in an index fund, you are investing in the market and the work is mostly computerized.
ACTIVELY MANAGED: The index fund’s counterpart is the actively managed fund which is managed by an individual manager, co-manager or a team of managers who choose the investments for the fund based on their investment expertise.
Which is better? That’s for you to decide. Yes, some great managers use their expertise to beat the market (aka index funds) but only 2 out 2,862 routinely do! Actively managed funds also typically have higher fees because you are paying for the staff to run them. That’s probably why Warren Buffet recommended that Lebron James invest in index funds and also told his own trustee to invest his estate in index funds when he leaves it to his heirs. Thanks Warren!