Diversification is a risk management strategy that involves spreading investments across different asset classes, industries, geographic regions, and individual securities to reduce exposure to any single risk. The principle behind diversification is that a portfolio of different investments will, on average, yield higher long-term returns and pose a lower risk than any individual investment. It is often summarized as 'don't put all your eggs in one basket.'
Diversification
Definition
Diversification is a risk management strategy that involves spreading investments across different asset classes, industries, geographic regions, and individual securities to reduce exposure to any single risk. The principle behind diversification is that a portfolio of different investments will, on average, yield higher long-term returns and pose a lower risk than any individual investment. It is often summarized as 'don't put all your eggs in one basket.'
Example
Instead of investing $100,000 entirely in Apple stock, a diversified portfolio might include: $40,000 in a U.S. total stock market index fund, $20,000 in an international stock fund, $25,000 in a bond index fund, $10,000 in a REIT fund, and $5,000 in a money market fund. If one sector declines, the others may offset the loss.
Key Points
- 1Reduces unsystematic (company-specific) risk
- 2Cannot eliminate systematic (market-wide) risk
- 3Over-diversification can dilute returns without reducing risk further
- 4Geographic diversification protects against country-specific economic downturns
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