Diversification

Diversification means buying stock in a range of different industries.

The idea is that,
because you cannot possibly know
which stocks will perform better or worse than average,
you cannot afford to put all your money into one company,
or even in companies within a single industry.

You have to spread the risk... And the opportunity!

Diversification of investment holdings is the most important shield against risk.
Because some investments rise in value while others fall,
diversification smoothes out much of the volatility of the overall return from a portfolio.
Diversification sacrifices some of the upside potential,
but this should be more than offset by the benefits of a lower level of risk.

The trade-off for the balancing of risk and return in a diversified portfolio
is that your overall return might be somewhat lower than you could get in an undiversified portfolio.
However, along the way, a diversified portfolio will have less volatility, and steadier returns.

The point is: Don't put all of your eggs in one basket!

Only by diversifying you will be able
to realize your average return objective with lower risk.

The right level of diversification for you at a given time depends on a variety of factors,
including where you are financially, what your goals are, and what the market is doing.

Though literally everyone talks about diversification for their investment portfolio,
very few understand the true statistical data underlying the definition.

As a result, the majority of portfolios are not properly diversified
and an extended risk is being taken, unquestionably unwittingly,
but nonetheless evident, by most investors.

In order to cope with the above problem, you have to understand the following:

Systematic Risk
This is a risk due to the movement of the market itself.
The benchmark could be any Index.
If you have one or a few investments in a given area,
you could compare its return to that of the benchmark index to determine how well it is doing.

Unsystematic Risk
This is the risk of a single company causing a significant move, either up or down.
This is usually the risk that most investors would want to eliminate,
unless they are "true risk takers"!
This risk may be tempered and in fact virtually eliminated,
by the purchase of an increased number of stocks.

Time Risk
It is usually known that the longer one holds an investment, the less the overall risk.
It means that sometimes if you have a risky stock, risk would lower the longer the stock was held.

Proper diversification is the foremost issue in all efficient investments,
especially where individual stocks are purchased.
It is impossible to properly judge a portfolio if the risk factor is missing.
And even if you understand your holdings,
it is mandatory that you must "know your self", and therefore have detailed knowledge of all your investment assets
in order to be able to determine the proper diversification and risk.

Back to the First Page | Back to the Investor Education