Clarify what diversification really means, and why it matters

When you sit down with a client for the very first time, what happens when you start talking about diversification? I’m betting you talk about picking a mix of investments, like stocks and bonds, maybe even some cash or real estate. You probably even discuss risk (another fun word). But I’m betting that most of your first-time clients leave not understanding why diversification matters.

It’s no huge surprise. After all, the talking heads on TV tend to focus most of their commentary on individual investments, like owning stock in Apple or buying a Treasury bond. If diversification does get mentioned, it’s rarely explained in any detail. So we need to make sure that people understand what diversification means and why it matters.

Here are a couple of things to review during your diversification discussions:

First, we’re taking different types of investments and mixing them together into one investment portfolio. I know, I know. It seems obvious to us, but you’ll be surprised at how many people don’t appreciate this principle.

(More from Carl Richards: How to keep clients away from shiny new investing trends)

Second, investors will always be unhappy with some investment in their portfolios, because that’s the point of diversification. One investment zigs while another zags. The zigging and zagging allows us to take two risky assets and blend them together to make a less risky portfolio.

That’s magic.

And your clients won’t know about this magic unless you tell them. In the meantime, they might think it makes perfect sense to go all in on oil stocks — maybe not so much right now. Or maybe they decide they can figure out how to time the market and avoid the next 400-point drop. Or maybe they believe they can pick the “perfect” investment.

In all these situations, investors are accepting an unnecessary level of risk. Diversification offers a way for investors to get a return that will help them reach their goals with significantly less risk. That seems like an important concept to make sure your clients understand.

Carl Richards is a certified financial planner and director of investor education for the BAM Alliance. He’s also the author of the weekly “Sketch Guy” column at the New York Times. He published his second book, The One-Page Financial Plan: A Simple Way to Be Smart About Your Money (Portfolio) last year. You can email Carl here, and learn more about him and his work at BehaviorGap.com.