In its simplest definition, diversification means to give variety or extend into multiple fields. The concept of diversification is best applied to investments.
When you diversify, you mix a variety of investments in equities, bonds, cash and other asset classes like gold and real estate within your portfolio. These investments often react differently to the same market events. This ensures that at any given point of time, if some of these assets are down, then others will be up, thus balancing the overall risk of a big loss.
Let us take an example to understand diversification better.
Say, there are two companies A and B. Company A only sells mangoes and Company B only sells apples. You have the option of either investing all your money in Company A or Company B or dividing it between the two. If you invest your entire portfolio in Company A that sells only mangoes, you will have a strong performance and return on your portfolio in summer but a poor performance in winters, when mangoes don’t grow. The reverse will occur if you invest all your money in Company B, selling only apples.
So what do you do to ensure the steady performance of your portfolio? Let’s say you invest 50% in Company A and 50% in Company B. Since you have divided your investments between the two companies, you will have a steady performance in both summers and winters instead of having extremes in both seasons.
This is diversification and its goal is to reduce the risk in a portfolio. Diversification can be done at many levels like spreading investments by assets, having a mix of equities, bonds and liquid instruments like cash. One can further look at diversifying by sectors, geographies (exposure to global markets), market capitalisation (large-cap, mid-cap and small-cap) or investing styles (active or passive investing strategy).
As a trade-off for lowering the overall risk, in the short-term, you may feel that your overall returns from a diversified portfolio are lower than the returns you could get in a portfolio that is not diversified. However, in the long-term, a diversified portfolio gives better performance, leading to steady returns.
You can determine the mix of investments based on your investment time frame, financial needs, and comfort with volatility. Also, diversification alone is not enough. Once you have arrived at a target investment mix, it is important to keep it on track with periodic reviewing and rebalancing.
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