Diversification (finance)

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Diversification is a portfolio strategy used when purchasing investments to cut back on exposure to risk. It is used on investments like stocks, bonds, and real estate which all move in different directions. The volatility of these investments is limited because not all industries or individual companies move up and down at the same time or same rate. So diversification reduces both the upside and downside potential for risk and allows for more consistent performance under a wide range of economic conditions. To sum this up, diversification reduces exposure to risk by spreading investments over the industry instead of limiting to volatile investments. By spreading or diversifying investments it eliminates the extremes, protecting from major loses and major gains but provides a safe constant gain.

According to The Digerati Life there are 8 different ways to diversify and manage risk; across asset classes, across asset class variants, across securities or investments within each asset class, across industries and sectors, across financial institutions and fund families, across fund managers, across time horizons and levels of liquidity, and across time with dollar cost average (Digerati 1-4). In order to diversify across asset classes investments are made in all a number of different classes such as equities, government bonds, corporate bonds, cash equivalents, real estate, currencies, and gold. If investments are made across asset classes the risk is limited on the basis of not all will crash or climb at the same time causing an equilibrium. Diversifying across asset class variants consist of investing in the variants or sublevels of asset class. The variants consist of company size, geographical market, bond maturity, bond types, and commercial or residential real estate. This would be for an investor with an extensively large portfolio or who strictly wants to invest in a specific asset class. It limits the investors risk because companies can rise as fast as others fall. Diversifying across securities or investments within each asset class can best be explained by buying mutual funds, index funds, and managed funds. By investing in these funds the risk is automatically spread out. If an investor wants to invest in a specific industry but not put everything on one company then they should spread across that industry or sector. There are investments known as sector fund which allow an investor to which give holdings indifferent companies spreading the risk across that industry or sector. Diversifying across financial institutions and fund families consists of spreading your investment through different investment institutions because they too can fall from greatness, possibly leaving you with nothing. Along with diversifying across institutions it is also a good idea to diversify across fund managers. Some managers only want your money and to some you are just a number, so by investing with different fund managers you spread the risk of a manager dropping the ball on your investments. Depending on the reason for investing it is a good idea to diversify based on time and liquidity, keeping some investment fairly liquid and others not so liquid. This would be based strictly on the goal of the investment. Investments for big purchases like house, wedding, or car want to be liquid for ease of cashing in. On the other hand investments for long term structure like retirement or college can have a lower liquidity level since the money is not needed immediately. By thinking about this ahead of time and investing properly for each you save a potentially large lose because if an investment is made to purchase a new car in two years and the bond as ten years to maturity that would be a large lose. Lastly, diversifying across time with dollar cost average consists of investing over time periods instead of one fell swoop. This spreads risk because of market fluctuation and gives time to research companies that you’re not too sure about.

Some Examples
Over all diversification is highly practiced in the financial industry. All investment institutions and managers recommend starting and diversifying portfolio. If an investor decides not to diversify there is no one to blame other then themselves, because investments are not insured and there is nothing the institution or manager can do once everything is lost. Why would any investor want to have a high risk of losing everything when investments can be diversified so the risk is fairly minimal? There are no disadvantages to diversifying investments. Though some say you cannot receive high returns and that is not true. No they may not come as often an investor who is not diversified but the large loses will not occur as often either. So they cancel each other out and leave the investor will a safe responsible investment strategy that will earn them steady financial growth.