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Investors may be more likely to make more money through riskier investments, but a risk-adjusted return is usually a measurement of efficiency to see how well an investor's capital is being deployed. Some may argue diversifying is important as it also creates better opportunities. In our example above, let's say you invested in a streaming service to diversify away from transportation companies.
Then, the streaming company announces a major partnership and investment in content. Had you not been diversified across industries, you would have never reaped the benefit of positive changes across sectors. Last, for some, diversifying can make investing more fun. Instead of holding all of your investment within a very small group, diversifying means researching new industries, comparing companies against each other, and emotionally buying into different industries.
Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Modern portfolio trackers can help with reporting and summarizing your holdings, but it can often be cumbersome needing to track a larger number of holdings. This also includes maintaining the purchase and sale information for tax reasons.
Diversification can also be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line —from transaction fees to brokerage charges. In addition, some brokerages may not offer specific asset classes you're interested in holding. Next, consider how complicated it can be. For instance, many synthetic investment products have been created to accommodate investors' risk tolerance levels.
These products are often complex and aren't meant for beginners or small investors. Those with limited investment experience and financial backing may feel intimidated by the idea of diversifying their portfolio.
Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won't be a losing investment. Diversification won't prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio. Last, some risks simply can't be diversified away. Due to global uncertainty, stocks, bonds, and other classes all fell at the same time. Diversification might have mitigated some of those losses, but it can not protect against a loss in general. May cause investing to be more fun and enjoyable should investors like researching new opportunities.
Diversification is a common investing technique used to reduce your chances of experiencing losses. By spreading your investments across different assets, you're less likely to have your portfolio wiped out due to one negative event impacting that single holding. Instead, your portfolio is spread across different types of assets and companies, preserving your capital and increasing your risk-adjusted returns. Diversification is a strategy that aims to mitigate risk and maximize returns by allocating investment funds across different vehicles, industries, companies, and other categories.
A diversified investment portfolio includes different asset classes such as stocks, bonds, and other securities. But that's not all. These vehicles are diversified by purchasing shares in different companies, asset classes, and industries. For instance, a diversified investor's portfolio may include stocks consisting of retail, transport, and consumer staple companies, as well as bonds—both corporate- and government-issued.
Further diversification may include money market accounts and cash. When you diversify your investments, you reduce the amount of risk you're exposed to in order to maximize your returns. Although there are certain risks you can't avoid such as systematic risks, you can hedge against unsystematic risks like business or financial risks. Diversification can help an investor manage risk and reduce the volatility of an asset's price movements.
Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely. You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes, geographical locations, security duration, and companies. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night's rest.
Portfolio Management. Risk Management. Fixed Income. Your Money. Personal Finance. Your Practice. Popular Courses. Table of Contents Expand. Table of Contents. What Is Diversification? Understanding Diversification. Different Types of Risk. Benefits of Diversification. Problems With Diversification. Diversification FAQs. The Bottom Line. Investopedia Investing. Part of. How to Invest with Confidence. Part Of.
Stock Market Basics. How Stock Investing Works. Investing vs. Managing a Portfolio. Stock Research. What Is Diversification in Investing? Key Takeaways Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories.
Unsystematic risk can be mitigated through diversification while systematic or market risk is generally unavoidable. Investors can choose to pick their own assets to invest in; otherwise, they can select an index fund that is comprised of a variety of companies and holdings. Balancing a diversified portfolio may be complicated and expensive, and it may come with lower rewards because the risk is mitigated. A diversified portfolio may lead to better opportunities, enjoyment in researching new assets, and higher risk-adjusted returns.
Portfolio Diversification Pros Attempts to reduce risk across a portfolio. Potentially increases the risk-adjusted rate of return for an investor Preserves capital, especially for retirees or older investors May garner better investing opportunities due to wider investing exposure May cause investing to be more fun and enjoyable should investors like researching new opportunities.
Cons Generally leads to lower portfolio-wide returns May cause investing to feel burdensome, requiring more management Often results in more and larger transaction fees Does not eliminate all types of risk within a portfolio May turn your attention away from large future winners May be intimidating for inexperienced investors not wanting to buy index funds.
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In terms of stock, a diversified portfolio would contain or more different stocks across many industries. But a diversified portfolio could also contain other assets — bonds, funds, real estate, CDs and even savings accounts. Each type of asset performs differently as an economy grows and shrinks, and each offers varying potential for gain and loss:. As some of these assets are rising rapidly, others will remain steady or fall.
Over time, the frontrunners may turn into laggards, or vice versa. Diversification has several benefits for you as an investor, but one of the largest is that it can actually improve your potential returns and stabilize your results. By owning multiple assets that perform differently, you reduce the overall risk of your portfolio, so that no single investment can hurt you. Because assets perform differently in different economic times, diversification smoothens your returns.