Diversification definition -
If you look at diversification’s definition, it is a risk management strategy that mixes different investment products within a portfolio to yield higher returns and lower the overall risks. Now that we know what is diversification, let us understand how does diversification protect investors.
If you want to mitigate the risk and volatility in your portfolio, diversification is one of the best ways to do so. It helps to spread your investment in a manner such that your exposure to any one type of asset remains limited. Diversification is important in investing
because it allows you to balance your comfort level with risk against your time horizon.
One of the most popular forms of diversification in finance is asset allocation. It allows you to incorporate elements of different investment classes in your portfolio and protect it from the loss that can occur due to over-dependence on only one asset category. That brings us to the next question - what is a diversified stock portfolio
Essentially, a diversified portfolio is one that gets constructed of investment products with different risk levels and yields that helps in lowering the risk and leverage of the overall variability of the portfolio performance.
A diversified portfolio also tries out to level out the impact of unsystematic risk or specific risks. By owning a large number of investments in different industries and companies, the risks associated with them specifically get minimized. That ultimately decreases the volatility of the portfolio, smoothing out the returns of the portfolio as a whole. Diversification is important in investing because of all the above reasons.
Now that we know what is a portfolio in finance, how does diversification protect investors and the necessity of diversification in finance and investing, let us take a more detailed look at the four primary components of a diversified portfolio -