Diversification is an investment strategy that involves spreading or allocating your investments across different assets or asset classes. The goal is to reduce the overall risk in a portfolio by avoiding putting all your eggs in one basket. Instead of investing in a single company's stock or a single type of asset, such as real estate or commodities, diversification involves holding a mix of investments with low correlation to each other.
Diversification helps reduce the risk of substantial losses in a portfolio because different assets can respond differently to various market conditions. When some investments may be declining in value, others may be performing well, which can offset losses and stabilize overall returns.
Diversification is achieved by allocating funds across different asset classes, such as stocks, bonds, cash, real estate, and commodities. Within each asset class, further diversification can be achieved by selecting different investments with varying characteristics. Investors can tailor their portfolios to their risk tolerance, financial goals, and investment time horizon. Younger investors with a higher risk tolerance may opt for a more aggressive and diversified portfolio, while those closer to retirement may choose a more Sconservative mix.
By diversifying, investors avoid the risk of being overly concentrated in a particular investment or sector. For example, if an investor holds only technology stocks and the tech sector experiences a downturn, their entire portfolio would be at risk. While diversification may limit the potential for extraordinary gains from a single investment, it provides a more stable and potentially smoother growth trajectory over the long term.
Regularly reviewing and rebalancing a diversified portfolio ensures the allocation remains in line with your objectives. As some assets may outperform others over time, rebalancing helps maintain the desired risk level.