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. Portfolio Investment

    A holding of an asset in a portfolio. A portfolio investment ...
  2. Holdings

    The contents of an investment portfolio held by an individual ...
  3. Price Risk

    The risk of a decline in the value of a security or a portfolio. ...
  4. Diversity Score

    A measure, created by Moody's Investors Service, to estimate ...
  5. International Portfolio

    A grouping of investment assets that focuses on securities from ...
  6. Managed Futures

    An alternative investment strategy in which professional portfolio ...
Related Articles
  1. Investing Basics

    Concentrated Vs. Diversified Portfolios: Comparing the Pros and Cons

    Examine the relative advantages and disadvantages of utilizing either a concentrated or a diversified investment portfolio strategy.
  2. Investing Basics

    Introduction To Investment Diversification

    Reducing risk and increasing returns in your portfolio is all about finding the right balance.
  3. Insurance

    The Dangers Of Over-Diversifying Your Portfolio

    If you diversify too much, you might not lose much, but you won't gain much either.
  4. Retirement

    Risk and Diversification: Diversifying Your Portfolio

    With the stock markets bouncing up and down 5% every week, individual investors clearly need a safety net. Diversification can work this way and can prevent your entire portfolio from losing ...
  5. Financial Advisors

    How to Help Clients See Value of Diversification

    One of an advisor’s most important jobs is getting clients to understand the value of diversification. Here are some tips that will help.
  6. Investing Basics

    In Praise Of Portfolio Simplicity

    Find out how you can streamline your investments for greater returns.
  7. Investing Basics

    Diversification Beyond Stocks

    If you think holding several stocks means you're diversified, think again - there's much more to be done to reduce portfolio risk.
  8. Active Trading

    Modern Portfolio Theory: Why It's Still Hip

    See why investors today still follow this old set of principles that reduce risk and increase returns through diversification.
  9. Active Trading

    When Geographic Diversification Fails

    Geographic diversification is becoming an ineffective investing strategy, but there are others that pay off in the long term.
  10. Options & Futures

    Investing 101: Portfolios And Diversification

    It's good to clarify how securities are different from each other, but it's even more important to understand how their different characteristics can work together to accomplish an objective. ...
RELATED FAQS
  1. How are negative correlations used in risk management?

    Learn about risk management and how negative correlations between assets are used to diversify and hedge risk associated ... Read Answer >>
  2. How does market risk differ from specific risk?

    Learn about market risk, specific risk, hedging and diversification, and how the market risk of assets differs from the specific ... Read Answer >>
  3. What is the ideal number of stocks to have in a portfolio?

    First off, there is no single correct answer to this question - it will depend on a number of factors such as your country ... Read Answer >>
  4. How is portfolio variance reduced in Modern Portfolio Theory?

    Learn about modern portfolio theory, specifically what it asserts about asset allocation and managing portfolio risk through ... Read Answer >>
  5. What kind of stocks should I buy (Ex. Oil, Gold, Consumer, Bio, or Tech)?

    How many stocks should be in a buy and hold strategy? At what percentage gain should I start taking real prof... Read Answer >>
  6. How do fund managers use correlation to create portfolio diversity?

    Read about how contemporary investment fund managers use the concept of correlation to add diversification among assets in ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center