What is portfolio diversification and why is it important?

As a risk management strategy, diversification attempts to limit exposure to concentrated investments by including a variety of assets within a portfolio. Investors with diversified portfolios expect the positive performance of some investments to neutralize the negative performance of others. 

Portfolios can be diversified in many ways. Some examples:

  • Across asset classes (e.g. stocks, bonds, ETFs and REITs) 
  • Within asset classes (by investing in stocks from uncorrelated industries, for example)
  • By investing in both domestic and foreign markets

Advantages of diversification 

Portfolio diversification is generally good for reducing unsystematic risk (risk that is specific to an asset or industry, for example). The idea here is the same as the old adage “don’t put your eggs all in one basket.” - by spreading your investments across different assets, geographies and industries, you tend to reduce your portfolio’s volatility. 

Here's an example of how diversification works: 

If you were to invest 100% of your portfolio into a company that happened to go bankrupt, you’d lose all your money. However, if you counterbalanced your investment in the bankrupt company with investments in other unrelated companies, only part of your portfolio would likely be affected. 

Disadvantages of diversification

Diversification does not guarantee investors will not lose money and this kind of investment strategy doesn’t make portfolios immune to risk - especially when it comes to systemic risk (which affects a market in its entirety).

Diversified portfolios can also be hard to manage. The more assets you hold, the more time and effort you’ll likely have to spend monitoring which investments are doing well and which aren’t. 

Moreover, although diversification can reduce risk, it can also reduce reward. By reducing your exposure to any single investment and protecting you on the downside, diversification limits you on the upside as well.

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