Stock diversification involves investing in a variety of assets to mitigate potential losses. It does not involve investing all capital in one company and borrowing to invest in another. An example is investing $10,000 in two companies, ABC and DEF, to cushion the impact of losses in one company.
Stock diversification is an investment term used to describe the practice of buying shares in a variety of assets rather than putting all of your capital into a single investment. The purpose behind stock diversification is to mitigate any loss that may accrue should something happen to any investment. Such a scenario will be easier to bear if there are other assets that help the investor absorb the impact of losses suffered in one of the investments.
For example, an investor with $20,000 might decide to buy some shares in companies as investments that are expected to earn dividends. The investor might decide to invest in ABC and DEF companies by purchasing $10,000 worth of shares in each. In the event that ABC declares bankruptcy and the value of the shares plummets until they are virtually worthless, the investor will not suffer a total loss since they still have the $10,000 shares in DEF, which they are doing very well. . This is in contrast to the total and devastating loss the investor would have suffered if he had deposited all the money with ABC.
When determining stock diversification, it’s important to note that this only refers to a situation where the investor splits the investment into hands across different companies and industries. Stock diversification does not apply when an investor who has $20,000 to invest puts all the money in one company and then borrows or takes more money in another to buy more shares in another company. In this type of situation, the investor is not mitigating his own risk, rather, that investor is increasing the risk by putting more money than he can comfortably invest in the two companies.
Still using the example of Company ABC and Company DEF, imagine that the investor only has $20,000 to invest. This investor has the option to split the $20,000 into ABC Company and DEF Company, but decides to put all the money into ABC. He or she then receives money from other sources in others to buy shares in DEF Company. Such an investor is not practicing stock diversification, but rather he or she has increased risk exponentially, because if ABC Company goes bankrupt, the investor will still lose all $20,000 instead of just $10,000, which would have helped cushion the shock. of the crisis. loss. At the same time, there is also a risk that the shares purchased in the DEF company may lose something if their value is due to some future factor.
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