Diversification Theory
Nick Name
Diversification
Diversification Theory refers to portfolio diversification that tackles the fundamental concept in investing. A form of a risk management strategy, it combines a variety of assets to reduce the overall risk of an investment portfolio, while lowering the volatility by holding non-correlated assets to eliminate unsystematic risk. It is an investing technique used by allocating portfolio resources or capital to a mix of different investments, unequally affected by specific market volatility, to possibly offset losses in one asset class with gains in another asset class. This theory remains an often employed tool by investors worldwide to strategize their investment allocations. Factors to consider include types of investments, risk levels, industries, and foreign markets. Nowadays, index and mutual funds, as well as ETFs, provide individual investors with a simple and inexpensive instrument for creating a diversified investment portfolio.
- Diversification involves investing in investments (or asset classes) that aren't tightly correlated
- Returns of a diversified portfolio are usually great than those of a concentrated portfolio
- Risks (volatility) of a diversified portfolio is usually less than those of a concentrated portfolio
- A diversified portfolio tends to give a higher level of return for the same amount of risk as an undiversified portfolio
- Diversification is a critical component of risk management
- Diversification minimizes permanent losses of capital, decreased portfolio income during recessions, and helps to avoiding low long-term returns.
- Diversification goes beyond the # of companies you own. It also includes diversifying by sector, industry style and asset class.