Diversification

Loading the player...

What is 'Diversification'

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

BREAKING DOWN 'Diversification'

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.

Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.

Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity. Buying shares in a mutual fund can provide investors with an inexpensive source of diversification.

RELATED TERMS
  1. Constant Ratio Plan

    An asset allocation strategy in which assets are assigned a fixed ...
  2. Burst Basket

    A burst basket refers to a particular type of stock transaction ...
  3. Idiosyncratic Risk

    Risk that is specific to an asset or a small group of assets. ...
  4. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected ...
  5. Modern Portfolio Theory - MPT

    A theory on how risk-averse investors can construct portfolios ...
  6. Asset Allocation

    An investment strategy that aims to balance risk and reward by ...
Related Articles
  1. Personal Finance

    3 Differences Between Average Joe and Mr. High Net Worth

    Take a look at how income levels and financial circumstances dictate decisions for today's eclectic group of market advisors and investors.
  2. Mutual Funds & ETFs

    3 Best High-Yielding Blended Bond Mutual Funds (RSHIX, EIHIX)

    Learn about three high-yield bond mutual funds with strong track records and excellent fundamentals that make sense as part of a balanced portfolio.
  3. Investing Basics

    3 Growth Investing Strategies for Beginners

    Learn how to pursue a basic growth investment strategy and take some preliminary steps to ensure a smooth transition into the equity arena.
  4. Investing News

    3 Bonds that Are Top Bets for Retirement in 2016

    Learn about three bonds that are top choices for retirement in 2016, offering investors increasing yields and lessen market risks.
  5. Mutual Funds & ETFs

    Consumer Staples ETFs Are Attracting Assets in 2016 (XLP, VDC)

    Learn about how the consumer staples sector reacts in times of market volatility and discover which ETFs in this sector have seen the largest inflows in 2016.
  6. Mutual Funds & ETFs

    4 Best Dividend-Paying U.S. Equity ETFs (HDV, XOM)

    Explore detailed analyses of the top three U.S. dividend-paying financials ETFs, which have trailing 12-month dividend yields of over 5%.
  7. Mutual Funds & ETFs

    XLV vs. VGHCX: ETF vs. Mutual Fund Case Study

    Discover whether the Vanguard Health Care Fund or the Health Care Select Sector SPDR ETF is a better investment in your portfolio.
  8. Mutual Funds & ETFs

    VGENX: Portfolio Trends in 2016

    Evaluate the composition of the Vanguard Energy Fund, and study how the fund's makeup has evolved between March 2015 and March 2016.
  9. Mutual Funds & ETFs

    Top 5 Mutual Fund Holders of General Motors Stock (GM, TM)

    Discover which mutual funds own the largest positions in General Motors, and learn about the investment style and strategy of each of those funds.
  10. Mutual Funds & ETFs

    4 Steps To Building A Profitable Portfolio

    This is a step-by-step approach to determining, achieving and maintaining optimal asset allocation.
RELATED FAQS
  1. Are target-date funds a good investment?

    Discover why target-date funds (TDFs) are a smart choice for many investors looking for a hands-off approach to long-term ... Read Answer >>
  2. Can minors invest in mutual funds?

    Learn how UGMA or UTMA accounts including mutual funds can be set up for minors through a guardian who oversees the account ... Read Answer >>
  3. What percentage of a diversified portfolio should large cap stocks comprise?

    Learn more about achieving optimal diversification of an investment portfolio, and specifically about the percentage of large-cap ... Read Answer >>
  4. How can I determine if my portfolio is overweight in certain sectors?

    Learn why you should review your portfolio to determine if they are overweight in a certain sector, and find out why you ... Read Answer >>
  5. What percentage of a diversified portfolio should be exposed to the retail sector?

    Learn the steps investors use to determine their portfolio diversification strategy and how retail fits into some of the ... Read Answer >>
  6. What percentage of a diversified portfolio should be exposed to the utilities sector?

    Learn how investors determine how much of their diversified portfolio should be dedicated to utilities, a stable sector that ... Read Answer >>
Hot Definitions
  1. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  2. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
  3. Generally Accepted Accounting Principles - GAAP

    The common set of accounting principles, standards and procedures that companies use to compile their financial statements. ...
  4. DuPont Analysis

    A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are ...
  5. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  6. Economies Of Scale

    Economies of scale is the cost advantage that arises with increased output of a product. Economies of scale arise because ...
Trading Center