Diversification is probably the single most important safeguard in investing. The idea is simple: You avoid putting all your eggs in one basket. Instead, you build your portfolio with different types of assets. When one type of investment is doing poorly, another may be doing well. Your winners help offset your losers, and the value of your overall portfolio doesn't move up and down so much.
While there's no one-size-fits-all answer when it comes to diversification, finding the right asset mix doesn't have to be complicated. But you do need to know some basics.
Securities generally fall into one of three asset classes: cash investments, bonds, and stocks. Each one involves different risks and potential returns. You can mix different types of investments to come up with the combination of risk and potential return that's right for you. Take a look:
Cash investments are short-term loans to creditworthy borrowers. They are designed to conserve the principal value of your investment and provide income that rises and falls with short-term interest rates. Examples are U.S. Treasury bills, certificates of deposit (CDs), and money market instruments. Key risk: Because cash investments are conservative, they usually generate the lowest returns and are vulnerable to the effects of inflation.
Bonds are longer-term loans made to a company, government, or government agency. The borrower, or issuer, agrees to repay the principal after a certain period and also to make regular interest payments along the way. Key risk: If interest rates increase, bond prices usually fall. (Conversely, if rates fall, bond prices generally go up.)
Stocks represent partial ownership of a corporation. A stock can increase in value through a rise in the market price of its shares. Many stocks also pay dividends. Key risk: Stock prices move unpredictably based on the issuing company's performance, market swings, and the state of the economy. Stocks have yielded the highest returns over the long term but can also experience prolonged downturns.
Remember: How you diversify among cash investments, bonds, and stocks is one of the most important factors in determining both the long-term return and price swings of your holdings. So make sure you take the time to find the mix that is most appropriate for your financial goals, time horizon, and risk tolerance.
For More Information
To learn more about the asset classes or to get help determining a suitable investment mix:
Visit the Planning & Advice section of Vanguard.com™.
Call Vanguard® Participant Services at 1-800-523-1188. Associates are available Monday through Friday from 8:30 a.m. to 9 p.m., Eastern time.