Financial diversification is investing money in various types of investments rather than just one type of investment. The purpose of financial diversification is to minimize the risk of the investor losing all of their money. It also helps to increase the chances of the person maximizing the amount of return on their investment.
There are two types of risk associated with financial diversification: risks that are diversifiable and risks that are not diversifiable. Diversifiable risk typically relates to a specific sector or industry. Investors can control diversifiable financial diversification by making sure that they invest their money in a variety of industries, rather than just investing on one industry, such as biotech, for example. If an investor has all of their money invested in biotech firms and the biotech industry collapses, then the person loses all of their money.
Financial diversification situations that investors have less control over are the risks that are not diversifiable. Inflation is one of these types of risks. Interest rate changes, war and political problems can also adversely affect financial diversification.
Simply put, financial diversification requires an investor to spread their money around. Investors should spread this money around into conservative investments, moderate investments and riskier investment options. True financial diversification requires the investor to find the right mix of each of these types of investments to fulfill the overall financial goals of the investor.
For example, a certain percentage of the financial portfolio should be held in cash. Another percentage of the portfolio should be held in conservative investments. Another portion in moderate investments and the final percentage in risky investments. What the percentage of each type of investment is varies greatly from investor to investor,
True financial diversification is set up in such a way that if one portion of the portfolio is doing badly, then the other portions compensate for this. Financial diversification is a way of balancing an investment portfolio to offset losses.
There are different models of financial diversification that individuals and even professional financial advisors can follow. No one financial diversification model is better than another; it is simply a preference of the investor or the financial advisor. The best model truly depends on what the financial goals are of the investor.
Financial diversification is an ongoing process. As the markets change and move and investments go up and down the diversification of the investment portfolio may need to be changed and rearranged.