Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio.
Diversification lowers the risk of your portfolio. Academics have complex formulas to demonstrate how this works, but we can explain it clearly with an example:
Say you live on an island where the entire economy consists of only two companies: one sells umbrellas while the other sells sunscreen. If you invest your entire portfolio in the company that sells umbrellas, you’ll have strong performance during the rainy season, but poor performance when it’s sunny outside. The reverse occurs with the sunscreen company, the alternative investment: your portfolio will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you’d rather have constant, steady returns. The solution is to invest 50% in one company and 50% in the other. Since you have diversified your portfolio, you will get decent performance year round instead of, depending on the season, having either excellent or terrible performance.
There are three main practices that can help you ensure the best diversification:
- Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate.
- Vary the risk in your securities. You’re not restricted to choosing only blue chip stocks. In fact, it would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas.
- Vary your securities by industry. This will minimize the impact of specific risks of certain industries.
Diversification is the most important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some sort of risk.
Another question frequently baffles investors: how many stocks should be bought in order to reach optimal diversification? According to portfolio theorists, after around 20 securities, you have reduced almost all of the individual security risk in a portfolio. This assumes you buy stocks of different sizes from various industries.
Caveat : Ensure that “Are You Over-Diversified?”
- Asset Allocation (sandyyadav.com)