Diversification basically means managing risk and it is accomplished by mixing a variety of financial instruments within a single portfolio. The goal of diversification is to minimize the impact that the performance of any one security will have on the overall performance of the whole portfolio.The ultimate goal of the diversification is to reduce the volatility of the portfolio by offsetting the losses of one asset class by the gains of another asset class. Let me give an example, if you have only two companies in a town that sell Sunscreen and umbrellas and you invest in only the company that sells sunscreen, you would see a strong performance during the dry season but when it rains it there would be a poor performance. Like the saying goes ‘ Don’t put all your eggs one basket’, the safest way is to invest 50/50 in both companies so you would see a decent performance all year round instead of a great performance at a certain time of the year alone. This is just an example that shows that if diversification is applied properly, it can minimize risk and smooth out returns.
There are four practices which can help ensure optimal diversification of a portfolio:
- Types of investments: Divide your portfolio among multiple investment vehicles, such as cash, stocks, bonds, mutual funds, and more.
- Risk levels: Vary the level of risk in the securities in which you invest. Pick investments with varied risk levels. This will help to ensure that large losses are offset by gains in other areas.
- Industries:Vary your securities according to industry. This helps to reduce the impact of risks that are industry-specific.
- Foreign markets: An investor should not invest only in domestic markets. There is a high probability that the financial products traded in foreign markets are less correlated with the products traded in the domestic markets.
There is perhaps no single greater factor in helping an individual reach his or her long-term financial goals while minimizing risk than diversification. Nowadays, individual investors do not need to worry about portfolio diversification, because there is a wide variety of well-diversified financial instruments available in the market. Index and mutual funds, as well as ETFs, provide individual investors with a simple and inexpensive instrument for a diversified investment. Still, though, diversification is not a fail-proof guarantee against loss. Virtually any investment takes on a certain degree of risk, regardless of how much diversification you employ.