Don’t put all your eggs in one basket. This simple proverb captures the essence of diversification in finance. Portfolio- or investment diversification refers to spreading your money across different assets and securities. That way, if one investment turns sour, the impact on your investment portfolio will be limited. While there is a higher chance that you lose some money on any given investment, the probability of loosing all your money is considerably smaller.
How does diversification work?
To see why one should diversify, let’s consider the following simple example.
Suppose we want to invest in one or both of the following companies. The first company (company A) produces ice-cream. The second company (company B) produces raincoats. If next summer is hot and dry, company A will sell a lot ice-cream. Company B however, will not sell a lot of raincoats. However, if next summer is cold and wet, company B will sell a lot of raincoats and nobody will buy ice-cream. To implement diversification in practice, investors will make use of approaches such as Modern Portfolio Theory or Naive Diversification.
The problem is that, unless we know what next summer will be like, we don’t know which company will generate higher profits. Therefore, it’s clearly better to invest in both companies. But how much should we invest in each company? This is the question that modern portfolio theory tries to answer.
Portfolio- or investment diversification is a very important concept in finance. Diversifying a portfolio will ensure that you, as an investor, don’t loose all your money.