Diversification (Finance) and its benefits

Diversification is the most important technique available to investors. It helps you avoid losing all of your money in financial crisis. Diversification is allocating your investing capital to different asset classes with the goal to reduce your total risk. 

 

But question arises as to why to invest in variety of assets when some may perform poorly.  Why not invest only in assets with greater returns.  The simple answer is that investment returns depend on variety of future events, which nobody can reliably predict.

Diversification can help reduce the risk associated with these future events.

Making diversification effective can take more than simply spreading out your money in more than one asset. The real benefits of your diversification strategy can be fully achieved by owning uncorrelated multiple asset classes which behave differently under different economic conditions.

For example, having a portfolio of 30 oil and gas stocks isn’t diversification. Even owning stocks and bonds may not be sufficiently diversified. Investing in variety of unrelated industries is real diversification.   

Different assets are exposed to different types of risks. If one asset perform badly there are good chances that other assets would perform well and would nullify the impact of bad-performing asset.

Investors should distribute their investments in assets with varying degree of liquidity, risk, and potential of earning. If you are investing in financial markets, you may diversify by investing in real assets like gold or real estate. Financial markets also offer avenues for diversification. Bond market often moves in opposing direction to that of equity. Investing in bonds can save you during period of falling share prices.

Although no amount of diversification can save you from complete disaster but it provides your assets with considerable protection against random events.