What Is Diversification?
Diversification refers to a risk management strategy in which resources or funds for a portfolio are allotted to various investments.
By this, we mean that exposure to and reliance on any asset, holding, or security is limited.
Pooling all resources and directing them at a single industry, sector, market, or asset class significantly reduces risks in investment. This is because the impact of a volatile investment or underperforming asset can be easily balanced out by the others who are performing profitably at the time.
It is common to hear the phrase: ‘Do not put all your eggs in one basket’ thrown around in business circles and beyond. It means that if the eggs in one basket fall off and break, the owner would have some others left intact.
Mathematical models and feasibility studies have demonstrated that well-diversified portfolios of 25 to 30 stocks reduce risks in the most cost-effective manner possible. Spreading investments across the board reduces the return rate as the amount invested will be comparatively less than if they were concentrated on a few securities.
Diversification is hugely beneficial when the portfolio is filled with investments that do not move in lockstep, and this implies that ‘unsystematic risks’ are eliminated. Unsystematic risk is one where only single companies or a small group of companies are affected against inherent or systematic ones where entire markets are affected. As such, investors should look to stock up their portfolios with securities that only have a slight positive correlation or an outright negative correlation because this means the chances of them moving in the same direction are low.
Every investor should be looking to add new options along the following lines to diversify their security base.
Types of Investment: Exchange-traded funds(ETF), cash and short-term cash equivalents, stocks, bonds.
Risk Levels: Alternating low-risk and high-risk investments to balance out losses and gains.
Industries: Technology, manufacturing, energy, financial services, health care, real estate, utilities, communication
Foreign Markets: Paying attention to investments beyond borders.
If a specific individual is into real estate, manufacturing, and technology- for instance- there is a very slim chance that all three(3) options will suffer a dip in the market at the same time. Thus, if one of them has it wrong, the other(s) will compensate.« Back to Glossary Index