Diversification of Investment - Concept

Definition of 'Diversification'

1. In Corporate's term

Diversification is a corporate strategy to enter into a new market or industry which the business is not currently in, whilst also creating a new product for that new market.

2. In Finance and Investment's term

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

3. In Layman's term

Diversification is to distribute (investments) among different companies or securities in order to limit losses in the event of a fall in a particular market or industry. In the most general sense, it can be summed up with this phrase: "Don't put all of your eggs in one basket."

What is Diversification?

Taking a closer look at the concept of diversification, the idea is to create a portfolio that includes multiple investments in order to reduce risk. Consider, for example, an investment that consists of only stock issued by a single company. If that company's stock suffers a serious downturn, your portfolio will sustain 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.

Another way to reduce the risk in your portfolio is to include bonds and cash. Because cash is generally used as a short-term reserve, most investors develop an asset allocation strategy for their portfolios based primarily on the use of stocks and bonds. 

It is never a bad idea to keep a portion of your invested assets in cash or short-term money-market securities. Cash can be used in case of an emergency, and short-term money-market securities can be liquidated instantly in case an investment opportunity arises, or in the event your usual cash requirements spike and you need to sell investments to make payments. 

Also, keep in mind that asset allocation and diversification are closely linked concepts; a diversified portfolio is created through the process of asset allocation. When creating a portfolio that contains both stocks and bonds, aggressive investors may lean towards a mix of 80% stocks and 20% bonds, while conservative investors may prefer a 20% stocks to 80% bonds mix.

Regardless of whether you are aggressive or conservative, the use of asset allocation to reduce risk through the selection of a balance of stocks and bonds for your portfolio is a more detailed description of how a diversified portfolio is created rather than the simplistic eggs in one basket concept. 

With this in mind, you will notice that mutual fund portfolios composed of a mix, which includes both stocks and bonds, are referred to as "balanced" portfolios. The specific balance of stocks and bonds in a given portfolio is designed to create a specific risk-reward ratio that offers the opportunity to achieve a certain rate of return on your investment in exchange for your willingness to accept a certain amount of risk. 

In general, the more risk you are willing to take, the greater the potential return on your investment. As such, adopt an investment diversification plays an important role to minimize risk and maximize return in your investment plan and strategy.