Stock diversification is an investment term used to describe the practice of purchasing stock in a variety of assets rather than putting all of the capital into just one investment. The purpose behind the diversification of stock is to mitigate any losses that might accrue in the event that something happens to any investment. Such a scenario will be easier to withstand if there are other assets to help the investor absorb the shock flowing from the losses suffered in one of the investments.
For instance, an investor with $20,000 dollars might decide to purchase some stock in companies as investments that are expected to yield dividends. The investor might decide to invest in ABC and DEF companies by purchasing $10,000 worth of stock in each. In the event that ABC goes bankrupt and the value of the stocks plummet until they are virtually worthless, the investor will not suffer a total loss since he or she still has the $10,000 stock in DEF, which is doing very well. This is in contrast to the total and devastating loss the investor would have suffered in if he or she had put all of the money in ABC.
When determining stock diversification, it is important to note that this only refers to a situation in which the investor divides the investment at hand into different companies and industries. Stock diversification does not apply when an investor who has $20,000 to invest puts all of the money in one company and then borrows or obtains more money in other to buy more shares in another company. In this type of situation, the investor is not mitigating his or her risks, rather, such an investor is increasing the risks by putting more money than he or she can comfortably invest into the two companies.
Still using the example of the ABC Company and DEF Company, imagine that the investor has only $20,000 to invest. This investor has the option of dividing the$20,000 into ABC Company and DEF Company but decides to put all of the money into ABC. He or she then gets money from other sources in other to purchase shares in DEF Company. Such an investor is not practicing stock diversification, rather he or she investor has increased the risk exponentially, because if ABC Company goes bankrupt, the investor will still lose all of the $20,000 instead of only $10,000, which would have helped cushion the shock from the loss. At the same time, there is also the risk that the stock purchased in DEF Company might lose some if its value due to any future factor.