Diversification is a risk management strategy that mixes various investments within a contained portfolio.
What does that mean?
It’s a nice way of saying “not having all of your eggs in one basket”. The rationale behind diversification is having different asset classes working towards your specific goals will manage your risk more effectively. In other words, instead of having all of your eggs in one basket, you have 100 eggs spread across 100 different baskets.
For example, imagine you have $100,000 to invest and you decide to invest all of it in a local pizza shop. If that pizza shop does well, you do well. If that pizza shop goes out of business, you may have lost all of your investment. Now let’s imagine you $100,000 equally across 10 different businesses instead. Maybe a pizza shop, a car wash, a movie theatre, a corner store, etc. You’re spreading your risk across multiple investments and helping reduce your risk. Let’s say one of your investments doesn’t pan out, the car wash goes under. You would still have $90,000 invested across other businesses to continue to grow for you.
Why do people diversify?
Sure, you could invest all of your money with one stock, strike gold and increase your portfolio by tenfold. However the chances of that happening are unlikely. Sure you may have heard of day-trading stock, penny stock and so forth but there’s a very low likelihood of striking it rich by picking the right stock.
Investing all of your money in one stock could yield three results. It grows in value, it decreases in value, or it doesn’t move at all. Your time is money, and by allowing waiting for a single stock to break through, you could be giving up valuable time in the market.
How should I diversify?
An easy way to diversify is by purchasing a mutual fund. A single mutual fund could possess hundreds of different investments (like stocks and bonds) inside of a single fund, helping you diversify very easily. You would just want to make sure the fund you choose aligns with your investment goals.
What does all of this mean?
By purchasing specific investments, it will help you spread your risk across hundreds possibly thousands of different companies, managing your downside risk.
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