Stock market basics: The ins and outs of diversification

Julie Brownlee, Fsp Invest, 22 Jun. 2015

Tags: diversification, what is diversification, benefits of diversification, how diversification works,

If you’ve read about investing on the stock market, you’re likely to have come across the term diversification.

So what exactly is diversification? How does it work? And what are the benefits of diversification?

Read on to find out…

What is diversification?

Diversification involves dividing your wealth up amongst different investments. By doing this, you avoid becoming too reliant on one investment’s performance.

In other words, diversification is about ensuring you don’t keep all your eggs in one basket.

By diversifying, you reduce the risk (volatility) of your portfolio, whilst maintaining a decent rate of return.

Let’s take a look at an example…

If you only own stock in one company, your portfolio is entirely dependent on what the share price of this company does.

The benefits of diversification

On the other hand, if you had 15 different stocks in your portfolio, even if one or two of them don’t perform well, the other shares in your portfolio should help to compensate for this loss, especially if these stocks are in different sectors of the economy.

The best way to achieve diversification is to diversify within each asset class and across different asset classes. This is because different assets have a tendency to behave differently depending on what’s going on in the economy. In other words, their returns are uncorrelated.

For instance, bonds tend to do well when inflation is falling or is at low levels. Gold tends to do well during times of financial crisis.

The mix of assets you hold in your portfolio is very much down to your investment time horizon and your appetite for risk. This is known as asset allocation.

So there you have it. The ins and outs of diversification.

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