Allocating and diversifying

Compounding is great, but on its own, it’s not enough. There’s more to investing than sticking your money somewhere and leaving it alone for 20 years. When you invest, you also need to protect yourself against risk, or the possibility of losing money.

Look at an example. Pretend you invest in a certain stock you heard about — maybe a friend or relative recommended it. Everything seems to go great at first, but then the stock market starts heading down…and down…and down — and with it goes the value of your stock. Pretty soon what you invested is only worth half of the original amount.

Unfortunately, a loss like that can happen. But here’s a lesson: If you had taken a few steps to protect yourself against risk, things might have turned out differently. For instance, if you had spread your money out among different types of investments rather than putting it all in one stock, you might have lost less, or maybe even not lost anything. You might have even earned enough on other investments to come out ahead overall.

Rather than buying just one stock, you could have split your money between stock and bond investments. History has shown that when the stock market falls, the bond market often does well — and vice versa. By investing in both places all the time, you get the advantage of the one that’s doing better at any one time. The way you divide your money up among different types of investments is called your asset allocation.