Diversification is a popular tool to manage risk when investing. Selecting various types of investments helps avoid putting “all of your eggs in one basket.” Below is an example to help explain.
In an economy there are times of growth called expansion and times of decline called contraction. In the market, there are types of investments that do particularly well during expansion, but poorly in contraction and those that do the opposite. Say you invest all of your money in a company that does well during expansion. In that period your investment will do well, but during contraction your investment will decline. Depending on your specific objectives, you may want to put some of your money in a security that does well during expansion and some in a security that does well during contraction.
There are a few different steps in when it comes to diversification. The first is investing in different types of securities, which I will elaborate on in posts to follow. The second is utilizing different asset classes. The last step is selecting different industries – technology, healthcare, utilities, among many others.
Diversifying your investments is important with the goal of reducing your risk and maximizing your returns. Diversifying your investments seeks to reduce the volatility in your portfolio. Neither asset allocation nor diversification guarantees against market loss or greater returns. Next week I will be posting about the different types of investments.