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

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
Financial Concepts: Diversification
RELATED TERMS
  1. Compound Annual Growth Rate - CAGR

    The year-over-year growth rate of an investment over a specified ...
  2. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  3. Bid Wanted

    An announcement by an investor who holds a security that he or ...
  4. Multibank Holding Company

    A company that owns or controls two or more banks. Mutlibank ...
  5. Short Put

    A type of strategy regarding a put option, which is a contract ...
  6. Mean-Variance Analysis

    The process of weighing risk against expected return. Mean variance ...
  1. Why do stock prices change following news reports?

    Stock prices move up and down every minute due to fluctuations in supply and demand. If more people want to buy a particular ...
  2. How do I calculate the adjusted closing price for a stock?

    When trading is done for the day on a recognized exchange, all stocks are priced at close. The price that is quoted at the ...
  3. How do I find historical prices for stocks?

    Whether for research purposes, bookkeeping or even general interest in historical performance, this is a question that many ...
  4. How long can you short sell for?

    When an investor or trader enters a short position, he or she does so with the intention of profiting from falling prices. ...
comments powered by Disqus
Related Tutorials
  1. American Depositary Receipt Basics
    Economics

    American Depositary Receipt Basics

  2. Macroeconomics
    Economics

    Macroeconomics

  3. Capital Budgeting
    Investing Basics

    Capital Budgeting

  4. Stock Basics Tutorial
    Investing Basics

    Stock Basics Tutorial

  5. Binary Options Tutorial
    Options & Futures

    Binary Options Tutorial

Trading Center