What is Diversification?
Diversification in terms of investment relates to the use of different strategies to effectively control the risk associated with assets contained in a portfolio. The process usually involves creating a balance within the portfolio in terms of the different investments that the investor chooses to acquire and maintain. By balancing or diversifying the investments found in the portfolio, the investor is able to offset losses incurred with one type of investment with the gains earned with other investments. As a result, the portfolio is positioned to maintain its overall value even when some of the investments are not performing as well as the investor predicted.
The exact strategies that an investor uses to manage the process of diversification will depend a great deal on his or her personal investment style. Conservative investors will tend to focus on including different investments with a relatively low amount of volatility. For example, the investor may choose to go with several bond issues along with a few commodities that perform well from one season to the next, and settle on a few stocks that have a history of yielding a consistent return. In the event that the one of those investment types should undergo some unanticipated decrease, chances are the other two will remain constant or possibly increase in value slightly. This mix makes it easier to cover the losses sustained in one area of the portfolio with the gains made with the other assets.
Another approach to diversification may not focus on an eclectic selection of different types of investments, but on diversification within one particular investment type. Should the investor prefer to focus mainly on shares of stock, he or she may determine to create a balance between stock options that carry a low amount of risk, those that offer a slightly higher return along with a little more risk, and shares with a greater amount of volatility and the potential for a higher yield. In this scenario, the returns on the more stable and consistent stock options would offset any losses generated by the riskier stock offerings and keep the overall value of the portfolio within a given range.
Other strategies may be used to create a diversified portfolio. An investor who leans toward home bias may engage in diversification by balancing domestic investments with a few international investments. Asset allocation may play a role in the overall plan, with the investor determining to maintain specific percentages of different investment types within the portfolio. There is no one right way to achieve diversification with any collection of investments. As long as some of those investments are likely to increase in value when others are declining, the goal of protecting the investor from the ill effects of those losses is achieved and the portfolio can be considered properly diversified.
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