Diversification is the idea that investing in a variety of different assets can minimize certain risks. The idea stems from the fact that not all assets move up and down together, and some asset classes actually move in no harmony with the broad market. As a result, a diversified portfolio will theoretically have less risk than a non-diversified portfolio.
Why It’s Important
As mentioned above, the name of the game in investing is minimizing risk. Investing in a single stock can be risky – if something happens to that company, you could lose all your money in that stock. Now, if you expand that out to 20 stocks, the odds of all 20 going bankrupt is much less, and if one company does go under, it will only impact 1/20 of your portfolio, instead of 100% of it.
Beyond just investing in more stocks, you should also consider investing in different asset classes as well. Now, let’s take 20 stocks, and then high grade US Bonds. The portfolio even becomes less risky. However, with the addition of more and more diversification, the returns will usually become smaller, but also more predictable.
Also note, that not all risk is diversifiable. Only unsystematic or security-specific risk can be avoided. Systematic risk or market risk, such as the United States economy crashing, cannot be diversified fully.
How To Diversify
You can easily diversify your portfolio by setting up baskets of securities that meet your goals. For example, you could want a 60% stock and 40% bond portfolio. That is the first step in diversifying. Then, inside the stock portfolio section, you want to have some domestic stocks and some international. You can buy mutual funds or ETFs that meet that criteria.
Within the bond portion of the portfolio, you can also diversify with different types of bonds. For example, you can have US Treasury Bonds, but you can also invest in bonds from companies, or other municipal bonds.
All of this diversification can be achieved by investing in the right mutual funds or ETFs that match your goals.