By: Dan Hughes
Diversification, from a financial perspective, is a risk management technique that mixes a wide variety of investments within a portfolio. Simply put, diversification is used to spread out the investments that an investor makes in order to reduce the amount of risk involved with each investment. The diversification of funds is a very important tool to understand when investing, and most serious investors who have a lot of their money tied up in particular investment vehicles understand this. If one of their investments is doing poorly, it won't hurt them that much because not all of their money lies within that particular investment. Their other investments hopefully are either doing the same as they always are, or maybe one is doing better and can pick up the slack of the one doing poorly.
There are three main strategies that investors can use in improving their diversification. The first method is to spread the portfolio among multiple types of investments. These types of investment include stocks, mutual funds, bonds, and cash. The second way to improve diversification is to vary the risk in the securities. Within mutual funds, for example, an investor can choose between different securities that have different levels of risk. Some of these securities may include growth funds, balanced funds, index funds, and cap funds. The third way to improve the diversity of your investments is to vary the securities by risk, or by geography. Doing this will reduce the effect of industry- or location-specific risks, whether they be within your own country or another country.
Due to the poor current state of our economy, many investors have been feeling that maybe diversification doesn't work. However, for most people, it will work...eventually. Dr. William J. Bernstein of Money Magazine argues in favor of diversification and asks for nay-sayers to look at the alternatives before hating on diversification. The first alternative to diversification is to "put all your eggs in one basket - and watch that basket." Suppose you were a Japanese investor 20 years ago and only stuck to the Japanese market. While the stocks worldwide on average grew 4.9% annually, you, unfortunately, were losing 2.5% annually. The second alternative to diversification would be to "get out of the kitchen...if you can't stand the heat." If you were an investor in the late 90's and were told that there would be catastrophes in the markets soon to come. If you had sold your stocks, then you would be in an even worse position than if you were to stick with your diversified stocks.
Not every scenario is going to be the same or result in the same outcomes. However, the best way to prevent the worst outcome is to diversify your investments.