Diversification is a strategy that can be neatly summed up by the timeless adage “Don’t put all your eggs in one basket.” The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
A diversified portfolio should be combined with asset allocation. So in addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, you’ll also need to spread out your investments within each asset category. The key is to identify investments in segments of each asset category that may perform differently under different market conditions. For example; a small rise in interest rates would have a negative effect on the value of long term bonds but a positive effect on your cash holdings.
One way of diversifying your investments within an asset category is to identify and invest in a wide range of companies and industry sectors. For example; buy a bank stock, an oil & gas company, a technology company and so on. But the stock portion of your investment portfolio won’t be diversified, if you only invest in only four or five individual stocks. You’ll need at least a dozen carefully selected individual stocks to be really diversified.
To be truly diversified, you also need to invest in other countries as well as at home. Even if your portfolio is small, you could buy companies that are multinational because they get revenue from around the world. An example of a multinational company would be a company like “Apple”.
Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset category through the ownership of mutual funds rather than through individual investments from each asset category. Mutual funds make it easy for investors to own a small portion of many investments.
Be aware, however, that a mutual fund investment doesn’t necessarily provide instant diversification, especially if the fund focuses on only one particular industry sector. If you invest in narrowly focused mutual funds like an energy mutual fund, you may need to invest in more than one mutual fund to get the diversification you seek. .
As you add more investments to your portfolio, you’ll likely pay additional fees and expenses, which will, in turn, lower your investment returns. So you’ll need to consider these costs when deciding the best way to diversify your portfolio.
Risk and reward are inextricably entwined. You’ve probably heard the phrase “the bigger the risk, the bigger the reward”. If you intend to purchases securities – such as stocks, bonds, or mutual funds – it’s important that you understand before you invest that you could lose some or all of your money.