Understanding Diversification

How many times have you heard, "don't put all of your eggs into one basket" when discussing investments?  Simply, the phrase means you shouldn't invest all of your money into one company, but there is much more to diversification than that.

Diversification: Defined

The idea of diversification is to create an investment portfolio that reduces risk by including multiple investments with more than one company, and multiple types of investments.  If you invest your money into the stock of one company, and that company fails- your investment portfolio is going to be hit hard by the decreased value of the stock.  When you split your investments up among more than one company, you are reducing risk to your investment portfolio.

A better way to diversify and reduce risk is to include investments other than stocks.  Investing in a variety of stocks and bonds for instance, further diversifies your investment portfolio, and provides a balance between high or medium risk investments with low risk investments.  It is a good idea, also, to keep some of your invested assets in cash form- such as in a high interest savings account or a money market account so you can easily obtain access to cash if there is an emergency.

If you are a young investor, you could be considered an "aggressive investor". Your investment portfolio might consist of 80% stocks and 20% bonds, while an older investor who is more conservative might prefer the reverse.  Both conservative and aggressive investors should allocate their assets in a way to reduce risk as much as possible, by selecting quality performing stocks, with a variety of low risk bonds to create a well-balanced portfolio.

How to Diversify Your Portfolio

Whether you are limited to a strict budget or you want the most uncomplicated investment strategy possible, you could create a balanced portfolio by choosing what is called "a single balanced mutual fund".  These mutual funds are actually made up of a mix of stocks and bonds already, so you can invest in the single fund, and still have a diversified portfolio.  The disadvantage is you don't get to select the actual stocks and bonds within the fund to invest in- they are already selected. 

The single balanced mutual fund option is also probably not the best option for individuals with large sums of money to invest.  With large sums of money for investments, you will want to minimize capital gains taxes and work on selecting investments that help you generate reliable streams of income.

There are more choices for diversification when you select your own stocks and bonds, and you can focus on specific needs- such as short term goals and long term financial goals.  You can make your decisions based on your tolerance for risk and personal factors, such as your age and financial requirements.

You can diversify your portfolio further than stocks, bonds, and cash by including a variety of further investments.  Real estate investment trusts, and hedge funds are outside of the traditional financial market of investments, but can calculate a financial gain and assist you in diversifying your portfolio.