You’ll probably see the term “diversification” if you read about investing, but it’s often described in a highly technical way. We’re here to demystify diversification and explain it without the jargon.
Don’t put all your eggs in one basket. You’ve probably heard that saying before, but did you know the same idea can apply to investing? Well, it can, and it’s called diversification when used in the context of finance. Diversification is frequently presented with academic language and complex formulas, but, essentially, it’s just a reminder not to put all your portfolio’s eggs in one financial basket. Let’s explore what diversification is, what it isn’t, and how this concept may help you invest your hard-earned money.
What Diversification Is
Diversification means that it’s generally better to spread your money across multiple investments than to bet everything on one stock. When you select investments that are dissimilar, such as a Treasury bond and a stock fund, diversification can become more effective. Meanwhile, holding several very similar restaurant stocks doesn’t provide much diversification. To reap the potential benefits of diversification, don’t just buy a bunch of stocks in your favorite industry; mix a variety of investments together in your portfolio. Owning a range of different investments is key to true diversification, not holding a number of related investments.
What Diversification Isn’t
While there’s a lot of research to indicate that diversification may reduce investment risks, diversification doesn’t guarantee you’ll avoid losing money. It’s not a sure way to make money with your investments either. Well-diversified portfolios have historically been less volatile than highly concentrated portfolios, but they can, and have, lost money in some years. A diversified portfolio also won’t be as exciting as whatever stock or investment is generating the most buzz at the moment. Diversification, then, should be viewed as a long-term investment approach instead of a magical way to get rich quickly.
How You Can Consider Diversifying Investments
Using investment funds, such as exchange-traded funds (ETFs), may help with diversification because funds typically hold dozens, or even hundreds, of individual stocks or bonds. Buying shares of well-diversified funds can be a more efficient way to invest in many assets simultaneously without the headache of placing a few hundred individual trades. Investment funds generally offer shares with affordable prices, too. For these reasons, many investors may find that funds provide the best “vehicles” for building a diversified portfolio.
A professionally-managed diversified portfolio includes multiple investment funds in one account. Portfolio managers seek to blend funds into a portfolio just as individual funds combine many stocks or bonds in their holdings. Managed accounts relieve investors of many investment tasks and provide professional oversight of portfolio diversification.
We hope this discussion of diversification gives you a better understanding of diversification and its potential benefits. In its most essential form, diversification acknowledges that markets are often unpredictable and highly complex. That’s why diversified portfolios avoid investing money in a narrow range of investments. The goal of investing is to grow your money, and diversified portfolios aim to capture gains across a wide range of assets. Portfolios lacking diversification can miss out on many investment opportunities. By spreading your money across many different investments, you can also hopefully avoid losing all your financial eggs due to one broken basket.
Because investments have risk of losing value and are not FDIC-insured, you should consider consulting a financial advisor before investing.
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