Why Is Diversification a Good Thing for Your Investments?

Diversification is one of the most important qualities of your investment portfolio, according to the U.S. Securities and Exchange Commission. Diversification means, simply, spreading your risk among several different types of investments. Investing all of your money in only stocks or in one mutual fund is the opposite of diversification. Diversification is the first step in managing your investment portfolio, but when done correctly, the process has several steps and continues throughout your investment life. Benefits of diversification develop over time.

Nolo reports that professional financial advisors remind investors not to place all of their eggs in one basket, which concentrates risk in one area. Diversification allows you take a risk in some investments while assuming less risk in others. You might lose some of your money, but not all. According to the U.S. Securities and Exchange Commission, cash and cash investments, such as money market funds, have the least risk and the lowest return among the most common types of investments. Bonds are higher risk with more return on investment, generally. Stocks have the highest risk and potential return as an investment choice. Real estate and commodities have varying degrees of risk. Some mutual funds provide diversification by investing pooled money in collections of many different investment vehicles, though some focus only on a particular industry.

Investors expect the ups and downs of investing, but severe market conditions increase risk. Diversification helps protect against such conditions. According to the SEC, market conditions that cause one investment category to exceed expectations can cause another investment type to perform poorly. Diversification aimed at limiting investment in any one industry, such as mortgage financing or health care, protects against serious, destructive financial downturns in that industry.

Diversification combined with asset allocation helps you set and achieve your financial goals. You base your asset allocation within your diversified portfolio on the length of time you need to realize a financial goal and your ability to tolerate risk. For instance, you might allocate more of your investment funds to riskier investments when you are in your 20s, but move the bulk of your money to more conservative investments when you are nearer retirement age, or a low-risk weighting of asset allocation choices could help to protect your initial investment when saving for a child’s education.

Diversification is not a one-time event; it can serve as a corrective many times to rebalance your investment portfolio. Over time, your portfolio can become out of balance in terms of risk, and require rebalancing to restore the protective benefits of diversification and asset allocation. Rebalancing requires restoring the original percentages of asset allocation among investment types. The ebb and flow of investment results may concentrate too much money in a few investment types. Rebalancing allows you to reapply your original diversification and asset allocation strategy and return your investment portfolio to prime risk-management condition.