Investment diversification involves spreading profits across multiple assets to reduce risks associated with investing in one asset or industry. Mitigating unsystematic risks through investing in a wide range of assets is key, and investing in uncorrelated portfolios across multiple asset classes can achieve a balanced and diversified portfolio. Diversification does not eliminate losses but helps reduce their impact on the investor’s overall asset base.
Investing diversification is the useful strategy of placing profits in multiple assets to reduce the risks associated with placing all profits in one asset or type of asset. For example, if an investor puts all of his or her money into stocks in one industry and that industry experiences something negative that devalues the stocks of associated companies, the investor may lose significant portions of his or her investment. However, if he places only a portion of the profits in that industry, while placing the rest in other stocks or investment vehicles, he only loses the portion invested in the aforementioned industry portfolio. The key to making diversification work is investing in multiple vehicles and categories to help spread risk evenly. This is generally achieved by selecting investment vehicles that will react differently under identical circumstances.
Unsystematic risks are the only risks that are diversifiable, meaning that the risks are specific to a certain company, industry, nation, and economy or investment vehicle. Often those risks include business or financial risks. Therefore, the goal is to mitigate those risks through investment diversification by investing in a wide range of assets that will respond differently to market changes. One example of this is investments in the transportation industry, where investors typically invest in multiple forms of transportation. In the event that a major event affects one mode of transportation, other parts of the portfolio will help offset the losses, because people will turn to those modes of transportation until the problem in the old industry is corrected.
Objectively, prudent investors will specifically aim to invest in uncorrelated portfolios. A transportation investor will not only look for companies that represent different modes of transportation, but will also look to invest in unrelated industries, such as financial institutions. Additionally, investors often go a step further and invest in multiple asset classes, such as stocks, bonds, real estate, and retirement plans. However, it is important to note that investment diversification does not reduce or eliminate losses, but rather helps reduce their impact on the investor’s overall asset base. Helps offset the consequences associated with companies reporting fraudulent numbers or also disseminating inaccurate information.
According to some experts, achieving investment diversification is not difficult, nor is it a complex project. Picking just a few stocks across a wide range of industries can help achieve a balanced and diversified portfolio, for example. However, multiple vehicles are often used because diversification only helps to reduce the risk of individual investments. Individual investment vehicles are not immune to general market risks that could affect the entire portfolio in an investment vehicle, regardless of the diversification in that portfolio. Balance is usually the goal, to achieve a compromise between risk and reward.
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