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What is investment diversification

By Edited Nov 14, 2015 0 1

When you read articles about investment, you will never fail to see the word diversification.

What is investment diversification? How do you manage investment diversification properly?

The purpose of investment diversification is to reduce risks in investing.

If you use all your disposable fund to invest in the stock of one company, you risk losing all your money when the company closes down.

If you divide your money equally to invest in five different companies, the most you will lose is just 20% of your capital if a company closes down.

That is the simple explanation of how you do investment diversification.

There are many considerations when it comes to the matter of investment diversification.

1. Diversification across different asset classes

If you have the money for it, you can and should diversify across different asset classes.

That means part of your capital in real estate, part of your money in stock market, and a third portion of your money in bond market.

Most rich people derive their money from their businesses, and they park it into stock market and real estate market. Some people invest in commodity market, and some people invest in currencies.

It does not matter how you handle investment diversification across asset classes, the most important factor is your investment knowledge.

If you know nothing about currencies, you must not sink a single cent into forex market. It is very risky to invest in something that you do not know.

2. Diversification within the same asset class

Let us suppose that you invest directly into the stock market.

You must not select stocks from the same industry. That goes against the principle of investment diversification.

If you choose 5 companies from the construction industry, that is not diversification at all.

When the construction industry is in a downturn, you will suffer paper loss. If you need to liquidate your holding, you will suffer a loss in your capital.

You need to invest in companies from different industries, preferably unrelated industries.

For example, you select one company in the construction industry, another company in the retail industry, the third company in the defense industry, and the fourth company is a pharmaceutical company. That is the way an investment diversification should be.

Some companies are pretty resistant to the economic crisis. They do not suffer losses even when the economy is in a downturn. For example, the waste management companies in charge of clearing the rubbish.

Some companies perform better in an economy boom. When you buy into the stocks of the companies during a downturn, you can expect to reap a fat harvest in the boom time.

The same principle of investment diversification applies in all other asset classes.

3. Risk of over-diversification

The real risk of over-diversification is the low rate of returns.

If you invest in mutual funds, and you have ten different mutual funds for different markets, you find it hard to gain from your investment.

You have to pay management fees for all the ten mutual funds. Some mutual funds are so diversified that the mediocre stocks drag down the profitability of the funds.

While the purpose of investment diversification is to reduce investment risk, over-diversification means that you are not going to gain from the stellar performer of the top companies.

It is best to avoid buying into too many mutual funds. One or two mutual funds will serve the purpose of investment diversification well.

If you want to avoid paying management fees, you can consider buying index funds instead. The cost of index funds is far lower than mutual funds.

You will notice that the rich people do not invest in mutual funds or index funds. They have enough financial knowledge to invest directly into the stock market, real estate market, commodities or forex. They do not need the investment diversification offers by the mutual funds or index funds.

If you have enough knowledge in investing, and enough money, you can invest like the rich people. You can get rich even faster.


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Comments

Sep 15, 2010 9:26am
danpowers
I don't know about mutual funds, I think they're overrated. In terms of daily income, my websites are now worth more than my pension fund.
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