Financial Concepts: Diversification
AAA
  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion

Financial Concepts: Diversification


Many individual investors can't tolerate the short-term fluctuations in the stock market. Diversifying your portfolio is the best way to smooth out the ride.

Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the overall performance of the portfolio. Diversification lowers the risk of your portfolio. Academics have complex formulas to demonstrate how this works, but we can explain it clearly with an example:

Suppose that you live on an island where the entire economy consists of only two companies: one sells umbrellas while the other sells sunscreen. If you invest your entire portfolio in the company that sells umbrellas, you'll have strong performance during the rainy season, but poor performance when it's sunny outside. The reverse occurs with the sunscreen company, the alternative investment; your portfolio will be high performance when the sun is out, but it will tank when the clouds roll in. Chances are you'd rather have constant, steady returns. The solution is to invest 50% in one company and 50% in the other. Because you have diversified your portfolio, you will get decent performance year round instead of having either excellent or terrible performance depending on the season. There are three main practices that can help you ensure the best diversification:

  1. Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds and perhaps even some real estate.
  2. Vary the risk in your securities. You're not restricted to choosing only blue chip stocks. In fact, it would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas.
  3. Vary your securities by industry. This will minimize the impact of industry-specific risks.


Diversification is the most important component in helping you reach your long-range financial goals while minimizing your risk. At the same time, diversification is not an ironclad guarantee against loss. No matter how much diversification you employ, investing involves taking on some risk.

Another question that frequently baffles investors is how many stocks should be bought in order to reach optimal diversification. According to portfolio theorists, adding about 20 securities to your portfolio reduces almost all of the individual security risk involved. This assumes that you buy stocks of different sizes from various industries. Financial Concepts: Dollar Cost Averaging

  1. Financial Concepts: Introduction
  2. Financial Concepts: The Risk/Return Tradeoff
  3. Financial Concepts: Diversification
  4. Financial Concepts: Dollar Cost Averaging
  5. Financial Concepts: Asset Allocation
  6. Financial Concepts: Random Walk Theory
  7. Financial Concepts: Efficient Market Hypothesis
  8. Financial Concepts: The Optimal Portfolio
  9. Financial Concepts: Capital Asset Pricing Model (CAPM)
  10. Financial Concepts: Conclusion
RELATED TERMS
  1. Cape Cod Method

    A method used to calculate loss reserves that uses weights proportional ...
  2. Kenney Rule

    A ratio of an insurance company’s unearned premiums to its policyholders’ ...
  3. Crowded Short

    A trade on the short side with an overwhelmingly large number ...
  4. Discounted Future Earnings

    A method of valuation to estimate the value of a firm.
  5. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  6. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  1. What dividend yield is typical for companies in the industrial sector?

    Find out more about dividend yields, what the dividend yield measures and what level of dividend yield is typical for companies ...
  2. Which REITs pay the highest dividends?

    Find out more about real estate investment trusts and which ones have dividend yields greater than 15% for the year 2015.
  3. What does it mean to be long or short a derivative?

    Find out more about derivative securities and what it indicates when traders or investors establish a long or short position ...
  4. What does Value at Risk (VaR) have to do with maximization of shareholder wealth?

    Learn about the value at risk statistical measure and how examining the VaR for their investments can help investors maximize ...

You May Also Like

Related Tutorials
  1. Fundamental Analysis

    Ethical Investing Tutorial

  2. Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Economics

    American Depositary Receipt Basics

  4. Economics

    Macroeconomics

  5. Investing Basics

    Capital Budgeting

Trading Center