Diversification is an important concept in investing. Investors and academics have demonstrated, in both theory and practice, that investing money in a variety of investment vehicles reduces both the risk and the volatility of the overall portfolio. This is because while some investments may decline in value under certain conditions, others will go up under those same conditions, and vice versa, so owning a little of both will smooth out returns over time.

To maximize the benefits of diversification, it is important to diversify across both asset classes, such as stocks, bonds, real estate, etc., as well as within asset classes, such as investing in the stocks of different industries, or in bonds of different duration and investment grades.

Diversification is the reason many retail investors opt to invest in mutual funds and similar investment vehicles; by using these vehicles, even with only a small amount of money they can be invested in hundreds of individual securities. However, it is a widespread myth that when it comes to diversification, more is always better. Research has repeatedly shown that a stock portfolio, for example, can achieve the maximum benefit of diversification with as few as 20 individual stocks, assuming those stocks are properly diversified across different industries, and that investing in more than 30 or 40 individual stocks actually reduces the diversification benefit.

Moreover, diversification works only to the extent that different asset classes and sectors within asset classes are not fully correlated to each other in terms of their price movement. However, for a variety of reasons that are not yet entirely understood, asset classes and industries are gradually becoming more and more correlated over time. This means that the benefits of portfolio diversification are gradually decreasing, and that it is gradually becoming harder and harder to diversify one's portfolio.

Di*ver`si*fi*ca"tion (?), n. [See Diversify.]

1.

The act of making various, or of changing form or quality.

Boyle.

2.

State of diversity or variation; variegation; modification; change; alternation.

Infinite diversifications of tints may be produced. Adventurer.

 

© Webster 1913.

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