Financial professionals often advise individual investors to diversify their portfolios and invest for the long term. To an inexperienced investor, understanding the reasons for this might be elusive. Learning more about the advantages of diversification strategies is beneficial for anyone considering a long-term investment or considering how to best position their portfolio for sustained growth.
Basics of Diversification
When considering an investment, a general rule financial professionals follow is that greater rewards come with greater risks. Maximizing a return while minimizing the potential for loss is often challenging, especially for inexperienced or part-time investors. Diversification strategies ways investors can limit their risk while also enjoying the potential for substantial rewards. Diversification is essentially the practice of purchasing investments in a variety of industries, markets and financial instruments. Understanding why and how to diversify is an important part of personal investing.
One of the key advantages to diversification strategies is that they help to limit risk. This is because a diversified portfolio is not overexposed to a single industry and therefore is somewhat insulated from downturns and volatility -- or market fluctuations -- in that industry. In addition, diversification limits an investor's risk extending from an individual company or type of investments -- for example, stability of bond investments protect an investor from losses in the stock market. By limiting risk with diversification, investors can be more confident their portfolio will be protected from substantial losses in one part of the market.
In addition to limiting downside risk, diversification strategies also have the effect of maximizing portfolio returns. This is in part because risk is limited -- by avoiding exposure to major losses, the portfolio can be more likely to make money. But diversification also maximizes returns by providing investor exposure to high-return growth industries. A safer but less-diversified portfolio -- for example, exclusive investments in treasury bonds -- are less well-positioned to take advantage of the profits enjoyed by high-growth industries than a diversified portfolio that includes those industries.
While diversification comes with powerful advantages, it is also important to remember some of the strategy's downsides. A diversified portfolio is still exposed to the challenges of systemic risk, or downturns that impact the entire market or the entire economy. Even diversified portfolios can suffer losses in serious economic crises. In addition, all financial investments, whether diversified or not, come with some risk and should be considered with the advice of an experienced financial planner.
- Securities and Exchange Commission; Beginners' Guide to Asset Allocation, Diversification, and Rebalancing; 2009
- Schwab MoneyWise; The Advantages of Diversification; 2010
- Universitat Pompeu Fabra; The Benefits of Emerging Market Diversification in Practice; Matteo Caruso, et al.; 2005
- Wall Street Pit; You Can't Mutualize, Insure, or Diversify Systematic Risk; Craig Pirrong; 2011
- Thinkstock/Comstock/Getty Images