What Is Diversification?

What Is Diversification?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

Diversification is a strategy that involves spreading your investments across various assets to reduce risk. It’s much like the saying “Don’t put all your eggs in one basket”. Instead of investing all your money in one company or one sector, you spread your investments across different companies, sectors, geographical sectors or different investment products like equities, fixed income securities, cash, etc. The goal here is to balance the risk and reward by allocating the investments in a calculated manner across entities with varying degrees of risk.

Related Questions

1. What is the main advantage of diversification in portfolio management?

The main advantage of diversification in portfolio management is risk reduction. By spreading investments across various assets, one ensures that losses from one investment are offset by gains in another. This process decreases the potential volatility and reduces the risk of substantial financial loss. Essentially, diversification is the financial equivalent of the saying, “Don’t put all your eggs in one basket”.

2. Can diversification guarantee profits?

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No, diversification doesn’t guarantee profits. It is a strategy to manage risk and not to maximize returns. It aims to achieve a balance between risk and return by spreading investments across different types of assets or sectors.

3. What’s the role of geographical diversification?

Geographic diversification is an aspect of portfolio diversification where investments are spread across different countries or regions. The aim behind doing this is to take advantage of the opportunities in different economies and buffer against uncertainties in one particular region.

4. How does diversification impact return on investment?

Diversification can potentially increase the return on investment by leveraging the investment opportunities in different assets or sectors. However, this is not a guarantee – the effect on returns depends on how well the individual investments perform.

5. How is diversification different from asset allocation?

Diversification and asset allocation are both techniques used to spread investment risk. However, there is a difference between the two. Asset allocation refers to the strategy of dividing your investment portfolio across different asset classes such as stocks, bonds, and cash. Diversification, on the other hand, involves spreading your investments within each asset class. In this way, if one investment or asset class performs poorly, the others may perform better, potentially offsetting the loss.