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Ever wonder why Mom and Pop stores sell wildly unrelated products side by side, like umbrellas and sunglasses, or Halloween candy and screwdrivers? Customers probably would never buy these items on the same shopping trip, right?
That’s exactly the point. By diversifying their product offerings, vendors reduce the risk of losing sales on any given day, since people don’t usually buy umbrellas on sunny days, or sunglasses when it rains.
The same diversification principle also applies in the investment world, where it’s referred to as asset allocation.
By spreading your assets across different investment classes (stock mutual funds, bonds, money market securities, real estate, cash, etc.), if one category tanks temporarily you may be at least partially protected by others.
You must weigh several factors when determining how best to allocate your assets:
Risk tolerance. This refers to your appetite for risking the loss of some or all of your original investment in exchange for greater potential rewards.
Although higher-risk investments (like stocks) are potentially more profitable over the long haul, they’re also at greater risk for short-term losses.
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