If you are new to the world of investing or are trying to brush up on your investment skills and knowledge, you may be curious about diversification.
The basic advantage of diversification is that it reduces risk by spreading funds over a variety of investments. Simply splitting up your money into two or more stocks is an example of diversification. If one investment fails, you still have the others to fall back on.
In order to truly diversify and spread the risk, however, you shouldnt just split your investments between any appealing stocks, but rather pick them from different industries. Purchasing some tech stocks and some stocks in a restaurant chain, for example, can protect you if one enters a downward swing.
When choosing which industries to invest in, it is best to find ones that are not considered to be highly correlated. If stocks in two industries would react similarly to adverse economic events, they are considered to be correlated. The higher the degree of correlation between your investments, the less diversification you achieve.
You may even wish to go beyond choosing investments that would be affected differently by adverse events and find several that have historically reacted in opposite directions. That way, if one investment suffers, it is more likely that your other investments will do well, so you can avoid panicking and pulling your investments too early if some are performing poorly.
Putting money into entirely different types of investments can protect you even further, as both the restaurant chain and the tech company in the previous example could be harmed by an overall downward swing in the stock market. If you choose two stocks and one other type of investment, however, you are further insulated from risks in the stock market.
It is possible to not only choose stocks that could react in opposite directions but also to diversify further by choosing entire investment types that are likely to move in different directions in response to economic events.
Generally, the bond and equity markets move in opposite directions, so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another, Investopedia says.
That is just one piece of the diversification puzzle, however. There are so many different ways to invest that your ability to diversify your investment portfolio is practically limitless. Once you achieve a solid foundation with a handful of diverse investments, you can have fun exploring all your options.
You should now add small-cap stocks and get even more diversification by owning a bond index fund, then add foreign stocks and foreign bonds, again with broad index products, states Forbes contributor Mitch Tuchman, managing director at Rebalance IRA. Add in some real estate and now youre getting close to a portfolio that actually is broadly diversified.
Through diversification, an investor can find a good balance between risk and reward. Although no investment strategy eliminates risk entirely, diversification can give you peace of mind and a financial edge to help your investments succeed over the long term.