Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt to limit exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. The investing in more securities generates further diversification benefits, albeit at a drastically smaller rate.
Remember, diversifying doesn't eliminate investment risk. Each fund has its own investment strategy, level of volatility, risk, and potential return. By comparing the differences, you can find the investment options that best meet your needs. However, diversification is not a guarantee against a loss.
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