What Is Investment Diversification?
Investment diversification is the purposeful strategy of placing gains in multiple assets to reduce risks associated with placing all gains in one asset or asset type. For example, if an investor places all his or her money in the stocks of one industry and that industry experiences something negative that devalues the stock of associated companies, the investor may lose significant portions of his or her investment. If, however, he or she places only a portion of gains in that industry, while putting the rest in other stocks or investment vehicles, he or she only loses the portion invested in the aforementioned industry portfolio. The key to making diversification work is to invest in multiple vehicles and categories in order to help spread risks evenly. This is usually accomplished by selecting investment vehicles that will react differently under identical circumstances.
Unsystematic risks are the only risks that are diversifiable, meaning that the risks are particular to a certain company, industry, nation, and economy or investment vehicle. Often those risks include business or financial risk. Therefore, the objective is to mitigate those risks through investment diversification by investing in a wide-range of assets that will respond differently to market changes. One such example is investments in the transportation industry where investors will often invest in multiple forms of transportation. In the chance that a major event impacts one form of transport, other portions of the portfolio will then help offset the losses, because people will turn to those forms of transport until the problem in the previous industry is rectified.
Objectively, prudent investors will aim specifically to invest in portfolios that do not correlate. Not only will an investor in transport seek out companies representing different modes of transportation, but he or she also will seek to invest in non-associated industries, such as financial institutions. Additionally, investors will often take this a step further and invest in multiple asset classes, such as stocks, bonds, real estate and retirement plans. Important to note, however, is that investment diversification does not reduce or eliminate loses, but rather it helps reduce their impact on the investor’s overall asset base. It helps to offset consequences associated with companies reporting fraudulent figures or disseminating inaccurate information as well.
According to some experts, achieving investment diversification is not hard, nor is it a complex project. Picking just a few stocks across a wide range of industries can help achieve a balanced and diversified portfolio, for example. Multiple vehicles, however, are often used because diversification only helps reduce risk on individual investments. Particular investment vehicles are not immune to overall market risks that might affect the entire portfolio in one investment vehicle, regardless of the diversification in that portfolio. Balance is usually the objective, in order to achieve a medium between risks and gains.
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