Diversification, don’t put your eggs in one basket, and spread your risks. What do all these expressions mean? I can tell you it does NOT mean what most brokers and financial advisors say it does .
Real diversification is what percentage of your money is in “risky” investments versus what is in “guaranteed” accounts. Risky investments could be stocks, mutual funds, or variable annuities. Safer guaranteed accounts could be savings accounts, money markets, CD’s, fixed annuities, or life insurance. In my practice, I have four areas of diversification, but at a minimum, everyone should divide their money into risk capital versus safe accounts.
Most brokers or financial advisors say diversification is how you spread your money in risky investments. For example, 30% in large cap growth and value funds, 30% in small and mid-cap growth and value funds, 20% in international funds and 20% in bond funds. The problem with this is that you can LOSE money in all of these accounts. They all have RISKS associated with them. This is not real diversification.
The rule of 100 is a simple, yet powerful rule that has worked for generations. Subtract your age from 100, and that is the figure that should be in “risky investments.” For example, a 70 year old should have 30% or less of their money in risky investments. A 30 year old should have 70% or less in risky investments.
Let’s look at real figures to illustrate how the rule of 100 protects you in the ups and downs of the market:
John & Betty have $200,000 invested, and are 50 years old. If they had the entire $200,000 in risky investments, and they dropped 20%, they would have $160,000. If they would follow the rule of 100, they would have $100,000 in risky investments, and $100,000 in safe guaranteed accounts. Let’s still assume they lost 20% in their risky accounts, leaving them with $80,000. But their $100,000 gained 5% in their safe guaranteed accounts, leaving them with $105,000. Following the rule of 100, they would have $185,000 instead of $160,000 not following the rule of 100.
At a minimum, you should follow this guideline. If you do, you will sleep better at night. Still, if you are a more conservative investor, you can always have more money in the “guaranteed” column.