Diversification is the only free lunch in the investment business and it is the best defense against taking devastating losses in your portfolio.
Diversification – Playing Good Defense
Diversification means not having so much of one thing that we make a killing, but also not being killed by any one thing. A properly designed investment portfolio must be properly diversified. On the equity side, it should contain hundreds of different stocks of companies in the US and abroad. On the bond side, it should contain many different types of bonds (government, municipal, corporate, mortgage, etc.) with different maturities and currency denominations. In more sophisticated investment portfolios, additional diversification can be achieved by adding asset classes like real estate and commodities because these asset classes have not been closely correlated with stocks and bonds over long periods of time.
The danger of concentrated positions.
A lack of diversification in an investment portfolio can be very dangerous to your financial health. There are many painful examples. Like the ex-Enron employees who had 100% of their 401(k) in Enron stock. Or, the investors who loaded up entirely on technology stocks just before the tech bubble burst in early 2000. Or, the bondholders who had substantial positions in Lehman Brothers in 2008. The list goes on.