What is “Diversification” and Do I Need It?

Photo Credit: Vox Efx via photopin cc

Photo Credit: Vox Efx via photopin cc

The term “diverse” often means “a wide variety of,” whether it is a diverse group of people, food, things, etc. This term is also a very popular term in a financial aspect that everyone should research and consider when managing their own money.

Financially, “diversification” means “reducing risks by investing in a wide variety of assets.” If the assets do not move up and down in a perfect, synchronized manner, then an individual with a diversified portfolio has less risk than the weighted average risk of its assets. Diversification can also be used to increase your overall investment performance, but doing so requires a lot of active management of the portfolio.

There are two types of diversification of a portfolio. Systematic diversification is the obverse of systematic risk, which is more difficult to achieve. Greater systematic risk is noticed when assets move up and down together in a union-like pattern. If this happens, there is large systematic risk and little systematic diversification.  The other type of systematic diversification is idiosyncratic diversification. This type of diversification is increased by simply holding more investments, and is much easier to achieve than systematic diversification.

The best way to explain and give an example of diversification is the phrase “don’t put all your eggs in one basket,” meaning do not only hold one stock because if that drops you are a higher financial risk. Having more investments an assets only means a lower risk of “dropping the basket and breaking the eggs.”

It is a good idea, in terms of financial growth and stability, for everyone to aim for a diversified financial portfolio. If you are not investing your money, you are not growing your money, which can severely hurt you in the event of a personal financial crisis. Having several assets and investments is a great idea for anyone who is managing their own money, and there are millions of great financial advisers to help you invest your money wisely and diversely.

One of the main issues in diversifying your portfolio is that, at the time that you are investing, you don’t necessarily know which assets will perform better. However, with that being said, this is why investing in several different and different kinds of assets is essential to your success in a diversified portfolio. The advantages of diversification definitely outweigh the disadvantages, however, if you are having second thoughts or need a professional opinion or assistance, it is best if you make an appointment with a financial adviser or accountant.

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