Investment diversification is the investment approach of spreading your capital among a variety of securities or asset classes to reduce the risk of the investment portfolio. Investment diversification is based on the idea that by investing in across many assets, bad performance of some assets will offset by good performance by other assets. 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.
Mathematically, diversification reduces the impact of market volatility on the portfolio and results in more stable returns over time. On this page, we discuss a very clear example of why investment diversification works and what kinds of diversification an investor can pursue.
An example of investment diversification
Don’t put all your eggs in one basket. This simple proverb captures the essence of diversification in finance. To see why putting this concept to practice in finance is useful, let’s consider a 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.
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?
To implement diversification in practice, investors will make use of statistical approaches such as Modern Portfolio Theory or simply rely on heuristics such as Naive Diversification.
Types of investment diversification
The above example of two companies is fairly simple. There, however, plenty of other ways in which we can diversify a portfolio. This includes:
- Asset class diversification: investing in a range of different asset classes, such as stocks, bonds, and cash, in order to spread risk across different types of asset classes
- Sector diversification: investing in different sectors within an asset class, such as investing in different industries within the stock market
- Geographical diversification: investing different companies and assets located in different parts of the world or countries within a region
- Investment style diversification: investing in different investment styles, such as momentum or value investment styles
Portfolio- or investment diversification is a very important concept in finance. Diversifying a portfolio will ensure that you, as an investor, are very unlikely to lose all your money.