Diversifying your investment portfolio can protect you from localized dips in the market, but it can also prevent you from making big money. The question of what breadth of diversification is appropriate is an ongoing conversation among financial professionals. Finding the right diversification level for yourself involves an analysis of your assets and your tolerance of risk.
Advantage: Risk Reduction
When your assets are widely diversified, your portfolio tends to perform in a similar way to the market as a whole. If you own stocks in 20 different areas and one of them takes a dive, it's unlikely that your portfolio will suffer terribly. Diversification is the best way to increase the stability of your investments and decrease your risk of losing money in the event that a single area decreases in value. Although diversification won't protect you from general market slowdowns, it will maintain your portfolio's stability over time.
Advantage: Asset Choices
When your holdings are widely diversified, you can spread them out over widely divergent forms of assets, including securities such as stocks and bonds, commodities such as oil and minerals, real estate and cash. Each of these assets exhibits different strengths and weaknesses in terms of risk and profitability. Maintaining holdings in all of these areas helps to create a stable portfolio that will increase in value over the long term.
Advantage: Lower Maintenance
Investments require a certain amount of care and attention to keep them performing well. If you are playing high-stakes games with your assets and moving them around through risky ventures, you will probably be spending a fair amount of time watching the markets and dodging financial bullets. A diversified portfolio is less exciting and more stable. Once you have your investments settled into a wide variety of stocks and securities, they can remain there for extended periods without requiring a lot of maintenance. This frees up your time to pursue other matters and reduces the market stress that may lead to burnout.
Disadvantage: Missed Windfalls
If your holdings are widely diversified, you are as unlikely to make a huge profit from a single sector as to suffer a huge loss. If 5 percent of your holdings suddenly spike, you will make far less profit than if 100 percent of your holdings were in that asset. In hindsight, many investors have regretted diversification after a small percentage of their holdings made a large profit. However, it is very difficult to predict where and when this will happen to an asset class or market sector. The more tightly your investments are focused, the higher risk you are taking, which can lead to large losses or to large gains.
Disadvantage: Increased Exposure
When your holdings are widely diversified, you will suffer some amount of loss whenever some part of your portfolio dips in value. If the market as a whole is declining, it is very likely that your holdings will do the same. When you diversify your investments, you protect yourself from excessive financial exposure, but at the cost of missing out on potentially major profits.