Portfolio diversification is important because it helps you balance risk and reward in your portfolio. In fact, several studies have shown that, on average, well-diversified portfolios generate more reliable returns than non-diversified portfolios over a period of 25 years or more.
Portfolio diversification is an investment strategy that works to manage risk while capitalizing on gains. It refers to the practice of spreading your investments around in various types of assets in an effort to cover different bases. Doing so also limits your exposure to any one type of asset, which can help to reduce the volatility of your portfolio over time. Basically: Portfolio diversification is just investment jargon for not putting all your eggs in one basket.
It’s important to note, however, that portfolio diversification does not help to reduce all risk. Systematic or market risk, for example, is unavoidable. Inflation and exchange rates, political instability, interest rates, etc. do not discriminate — these things do not affect a particular company or industry. Therefore, portfolio diversification won’t reduce all risks; some risks investors just have to be willing to accept.
There are different ways to diversify a portfolio, such as by asset class, sector, market capitalization, and correlation. Usually, investors select a mix of alternatives to diversify their portfolio to the fullest extent.
Most of the time, however, investors diversify their portfolios through asset allocation. By mixing up elements of different investment classes in your portfolio — such as domestic and international stocks, bonds, short-term investments (i.e. market funds and short-term certificates of deposit), real estate, gold and other commodities — you can protect your portfolio if one of those perform poorly. If you have both stocks and bonds in your portfolio, for example, your portfolio might not rise as quickly as it would if you had all stocks, but it probably wouldn’t fall as quickly either.
In investing, the main asset classes include:
It’s also smart to diversify within those varied asset classes.
In other words: Don’t just buy a ton of stock in one sector like the tech industry, for example. Switch it up to maximize your portfolio diversification. Many who subscribe to diversification divide their portfolios by what percentage of their portfolios each asset class will make up first. Depending on which asset classes an investor chooses, they may have more or less ways to split their investments further.
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