Diversification Definition

Diversification is an investing strategy for managing risk. When a business wants to diversify its assets, it invests in a wide range of companies, industries, and types of assets. This might mean investing in stocks, bonds, mutual funds, and even real estate. Read on to understand what the meaning of diversification could be for your small business.

What is diversification?

When a portfolio meets the diversification definition, it contains a mix of asset types. This is to limit the investor’s exposure to any single type of risk. A diversified portfolio, in theory, should not only protect you as an individual or a business owner from investment risk, but provide you with higher long-term results than holding any one type of asset. 

One major diversification benefit is that portfolio holdings can be diversified across asset classes, as well as industries and markets. The theory behind this type of diversification is that positive performance in one area of your portfolio can counter-balance losses in another area.

Diversification Examples

You can create a diversified portfolio using stocks, bonds, and mutual funds. One diversification example that some individuals use is called the 3-fund portfolio. Using just three index funds, investors have had success creating and maintaining a low-risk, diversified portfolio.

However you choose to construct and diversify your portfolio, diversification is an important growth and risk-management strategy. 

Diversification Benefits

We have already talked about many of the benefits of diversification. Some of the most important benefits include:

• Reducing portfolio risk for investors
• Reducing market risk for investors
• Smoothing gains and losses
• Offering higher long-term gains than investing in single asset classes alone
• Hedging against volatility

These benefits make diversifying your portfolio attractive not only because of the risk reduction aspects but also because of the potential economic gains. Whether you manage your own money or have an outside money manager working with you, be sure to consider and discuss diversification strategies.

Diversification Disadvantages

Despite its many benefits, there are some potential downsides to diversifying your assets. If your portfolio has many diverse assets it can become expensive and time-consuming to manage them. Buying, selling, and keeping track of reporting different assets in different markets on different exchanges involves more transaction fees and, often, higher broker commissions. And as Sir Isaac Newton is reported to have once said, “What goes up, must come down.” Meaning, that while diversification can increase your return on your investment, the spread-out strategies often significantly temper your potential reward as well. 

Diversification: Summary

• Diversification is a strategy that mixes a variety of investments in a portfolio.
• Portfolio holdings can be diversified across asset classes and markets.
• Diversification limits risk but can also temper performance.

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