“Don’t put all your eggs in one basket”
This is one of the most familiar and simplest quotes to explain diversification. The idea behind it is simple: If the basket falls, not all your eggs will be destroyed at once since they are spread out in different baskets.
While that belief certainly captures the essence of the issue, it provides little guidance on the implications of the role diversification plays in an investor’s portfolio and offers no insight into how a diversified portfolio is actually created. In this chapter, we’ll explain diversification and give you some insight into how you can make it work to your advantage.
What Is Diversification?
Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The theory behind this technique state that a portfolio constructed of different kinds of investments will, on average, yield higher returns and present a lower risk than any individual investment found within the portfolio because the positive performance of some investments neutralizes the negative performance of others. Therefore, the benefits of diversification hold only if the instruments in the portfolio are not perfectly correlated.
Money managers and investment professionals know the benefit of diversification which is why it’s an essential component of any retirement savings plan. No one questions the logic of diversifying investments when it comes to a retirement plan. Everyone knows that diversification lowers risk, and if done right, the good investments will outweigh the bad ones.
Taking a closer look at the concept of diversification, the idea is to create a portfolio that includes multiple instruments in order to reduce risk. Consider, for example, an investment that consists of only one stock issued by a single company. If that company’s stock suffers a serious downturn, your portfolio will take the full brunt of the decline. By splitting your investment between the stocks from two different companies, you can reduce the potential risk to your portfolio.
Further details can be found on Chapter 13 ” The Importance of Diversification ” from the free eBook “Trading Essentials: Strategies Built for Consistency” where you’ll learn more about :
- Why You Should Diversify ?
- How to build a diversified portfolio ?
- 3 Types of Diversification for Day Traders
- Modern Diversification
I highly recommend that you grab your free eBook copy where you’ll get a collection of 17+ methods designed for beginning, intermediate and advanced traders and investors including:
- Diversification Techniques
- The science of consistency
- The Butterfly Spread Method
- Using Price Action to Predict Market Turns
- A Winning Strategy for Small Accounts
- The 6 Market Inputs for Big Winners