Diversification is the portfolio strategy used to minimize the risk by allocating investments among various financial instruments or assets. Market volatility is limited by the fact that all asset classes move up and down in value at the same time and the same rate. The importance of diversification is that, it reduces market fluctuations and allows more consistent performance under a wide range of economic conditions.
Diversification aims to minimize risk and maximize return by investing in different areas that would each react differently to the same event. Any investment can be considered as risk, as every investment is subjected to unexpected changes. If you invest in only one stock or one sector, and that stock is hit with an unforeseen event, then you will certainly face a capital loss in your investment. But if your investment eggs are spread around, in various baskets of different characteristics, then the risk against inevitable change is reduced.
The smart and appropriate choice for most new investors is to choose several different types of mutual funds. As funds can hold shares of hundreds of different companies, investing in a mutual fund provides diversification among stocks. Another way of diversification can be done by investing in different sectors. For example, if you diversify your investments in sectors like technology, energy, utilities, capital equipment, consumer staples, the dips in one sector of the market may be over shadowed as others do well.
Good diversification involves investing money in different asset classes, some in shares, some in bonds, some in property, some in commodity. The amount you place in each asset depends on your investment goals and the level of risk you are prepared to take in order to achieve your desired high return. So, know the importance of diversification and invest wisely.