Importance of Diversification

Importance of Diversification

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. This article will focus on how diversification works and why it is necessary to diversify.

How Diversification Works

Stocks do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.

Whereas, bonds and other fixed-income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.

Importance of Diversification 2

Why You Should Diversify

Share Prices

Let’s say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value.

However, if you offset the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.

Different Asset Classes

It’s also important that you diversify among different asset classes. Different assets – such as bonds and stocks – will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio’s sensitivity to market swings.

Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

Different Diversification Types

There are additional types of diversification, and many synthetic investment products have been created to accommodate investors’ risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors.

For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify the stock market.

Less Fraud Impact

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee that it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

Conclusion

Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.

See Also: Downsides of Portfolio Diversification

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