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WalletPrep worksheet · Investing

What is diversification in investing?

Name ____________________ Date __________

Key ideas

  1. One broad fund beats a handful of stocks. A total market index fund holds thousands of companies, so one failure barely moves your balance.
  2. More funds is not more diversification. Funds that own the same companies add fees, not safety. Check the top holdings for overlap.
  3. Diversifying can't stop a market-wide drop. It shrinks the damage from one company failing. When the whole market falls, a diversified portfolio falls too.

Vocabulary

Diversification
Spreading your money across many investments so that one bad company or sector does less damage to the whole.
Stock
A small piece of ownership in a company. Its price rises and falls with how investors value the business.
Bond
A loan you make to a government or company. It pays you interest and returns your money on a set date, called the maturity date.
Index fund
A mutual fund or ETF that tries to match a market index by holding the investments in it, rather than picking winners.
ETF
Exchange-traded fund: a basket of investments that trades on a stock exchange throughout the day, like a single stock.
Asset allocation
How you divide your investments among types like stocks, bonds and cash, based on your goals, timeline and comfort with risk.

Work it out

Omar, 34, has $10,000 in his 401(k): $6,000 in his employer's stock and $4,000 in a total market index fund. Then his employer's stock falls 50%.

  1. Employer stock
  2. Index fund
  3. Total before the drop
  4. Employer stock falls 50%
  5. After the drop
  6. All $10,000 in the index fund
  7. Same drop at a 0.5% weight
  8. After the drop

Check yourself

  1. You have $20,000, with $8,000 in one company's stock. It falls 40%. How much do you lose?

    • A. $3,200
    • B. $8,000
    • C. $800
    • D. $4,800

  2. Which is the most diversified?

    • A. Three large-company US growth funds
    • B. Your employer's stock plus one tech fund
    • C. One total world stock index fund and one total bond fund

  3. What can diversification NOT protect you from?

    • A. One company going bankrupt
    • B. Most of the stock market falling at once
    • C. One industry having a bad year
    • D. Picking the wrong single stock

Your turn

List every fund and stock you own and what share of your total each one is. If any single company is more than about 10%, make a plan to move part of it into a broad index fund.

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Answer key

What is diversification in investing?

Work it out

  1. Employer stock$6,000
  2. Index fund$4,000
  3. Total before the drop= $10,000
  4. Employer stock falls 50%− $3,000
  5. After the drop= $7,000
  6. All $10,000 in the index fund$10,000
  7. Same drop at a 0.5% weight− $25
  8. After the drop= $9,975
  1. Omar's employer stock falls by $6,000 × 50% = $3,000, so his $10,000 becomes $10,000 − $3,000 = $7,000. That is a 30% loss from one company.
  2. Suppose his employer is 0.5% of the index fund. With all $10,000 in the fund, that company's share is $10,000 × 0.5% = $50.
  3. Half of $50 is $25, so the same drop leaves $10,000 − $25 = $9,975, ignoring how the fund's other companies move that day.

Check yourself

  1. A. $3,200 $8,000 × 40% = $3,200. That is a 16% hit to your $20,000 from one company.
  2. C. One total world stock index fund and one total bond fund A total world fund holds thousands of companies in many countries, and the bond fund adds a different asset type.
  3. B. Most of the stock market falling at once When most stocks fall together, a diversified stock portfolio falls too. Bonds, cash and time help with that kind of drop.