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Why You Need To Diversify Even Your Safe Money

Over the last two weeks, I've written a couple of posts on bonds to help you become a better bond investor. I covered how bonds can help keep you on track for retirement as well as making sure you own safe bonds. Today I'm going to talk about why the safe bonds you own also need to be diversified.

The basic reason to own bonds is because they're generally conservative investments that hold their value through all sorts of market cycles. So they usually provide a good hedge against declines in the stock market and serve as an important risk management tool in your portfolio.

But during this recent financial crisis, a number of what were considered high quality bonds or fixed income holdings collapsed in value. If you weren't diversified, you may have found out that your safe money went down along with your risky money, which can completely derail your retirement plans.

Sometimes, when people own bonds, they might only own a few because they believe the bonds are safe. Investors think, "if they're safe, why go through the hassle of owing a bunch of different ones?"

But safe doesn't mean no possibility of loss. It just means a lower probability of loss. If you only own a few bonds, and you're unlucky enough to own one that gets into trouble, you can lose a substantial percentage of your savings from one bad holding. You can easily reduce the probability of loss by simply diversifying.

  • Type. It's generally a good idea to own a basic diversified mix of U.S. government and high quality corporate bonds. U.S. government debt would include treasuries, savings bonds, as well as other types of debt that are fully backed by the U.S. government such as FDIC insured CDs. Corporate debt would include high quality bonds from companies in various sectors of the economy, such as technology, consumer staples, utilities, finance and industrials.
  • Number. A good rule of thumb is to make sure that no corporate bond holding represents more than 5 percent of your net worth. If the company happens to go bankrupt, then the loss is limited.
  • Funds. If you own bond funds, you're probably somewhat diversified because the funds usually own lots of bonds. But, fund managers do make mistakes. Last year, a number of bond funds had losses of more than 20 percent because, while they owned many bonds, the bonds they owned were too risky. To protect yourself, consider owning multiple high quality bond funds from different investment companies. That way, if one fund company makes a mistake on their investment strategy, you don't bear the full brunt of that mistake.
While this advice may sound simple, even professional investors made big mistakes in this area. Lack of diversification is the root of much of the current financial crisis. If banks and other financial services firms hadn't loaded up on so many mortgage bonds, we might not be in this mess.

Bottom line: Diversification is the primary building block of prudent portfolio management. Your bonds, as well as your stocks, need to be diversified. Yet, so many investors fail to do it. Don't learn this lesson the hard way.

As with all investment matters, consult your individual advisor prior to making any financial decisions.

If your safe money falls apart, it can of course create a real threat to your financial security because you are relying on the safe money to help you manage your risk.