Diversification is a growth strategy that takes advantage of market opportunities aiming to reduce the portfolio risk by allocating investment interest over different classes of assets. Through the acquisition and efficient management of two or more different assets, diversification leverages investment risk by offsetting losses from one asset with the gains of another asset in the same portfolio. As a result, as the number of the multiple assets in the portfolio increases, the total portfolio risk decreases.
Diversification is essential for all investors. Constructing a diversified portfolio is important to the growth of the investment. Savvy investors have different investment classes in their portfolio such as stocks, mutual funds, bonds, cash, or commodities and they protect their portfolio from losing value if one asset category declines sharply. However, although asset allocation may seem a straightforward form of diversification, still it requires a good knowledge of investment fundamentals.
The first rule of diversification is to know the basics of each investment class.
Stocks are financial assets of equity investing that offer ownership or a share of the company to the investor. When a firm is viable and profitable, its market capitalization increases and so does the value of its stocks. Stocks are generally considered as riskier than all other financial assets because they are susceptible to more frequent and sharper fluctuations and market volatility. Yet, as investors have different investment profiles that differ in the level of risk that are willing to undertake, the investment goals are directly proportional to the fluctuations of the stocks. Risk-takers investors invest in aggressive stocks, which generate instant income. Risk-averse investors prefer stocks that generate average returns on a long-term horizon.
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