Personal Finance: What is diversification and why is it important?
If you invest in a single security, your return will depend solely on that security; if that security flops, your entire return will be severely affected. Clearly, held by itself, the single security is highly risky. If you add nine other unrelated securities to that single security portfolio, the possible outcome changes—if that security flops, your entire return won’t be as badly hurt. By diversifying the investments in your personal financial plan, you have substantially reduced the risk of the single security. However, that security’s return will be the same whether held in isolation or in a portfolio. Diversification substantially reduces your risk with little impact on potential returns. The key involves investing in categories or securities that are dissimilar: Their returns are affected by different factors and they face different kinds of risks. Diversification should occur at all levels of investing. Diversification among the major asset categories—stocks, fixed-income and mo
