Diversification is a strategy that can be neatly summed up by the timeless saying "Don't put all your eggs in one basket." The strategy involves spreading your money among various investments in the hope that if one investment loses money, the other investments will more than make up for those losses.
By including asset classes with investment returns that move up and down under different market conditions within a portfolio, you can protect your investment portfolio against significant losses. Historically, the returns of the four major asset classes (Equities, Bonds, Cash and Property) have not moved up and down at the same time. Market conditions that cause one asset class to do well often cause another asset class to have average or poor returns. By investing in more than one asset class, you'll reduce the risk that you'll lose money and your portfolio's overall investment returns will have a smoother ride. If one asset class's investment return falls, you'll be in a position to counteract your losses in that asset class with better investment returns in another asset class.
The Magic of Diversification
A diversified portfolio should be diversified at two levels: between asset classes and within asset classes. So in addition to allocating your investments among shares, property, bonds, cash equivalents, and possibly other asset classes, you'll also need to spread out your investments within each asset class. The key is to identify investments in segments of each asset class that may perform differently under different market conditions.
One of way of diversifying your investments within an asset class is to identify and invest in a wide range of companies and industry sectors. But the share portion of your investment portfolio won't be diversified, for example, if you only invest in only four or five individual shares. You'll probably need at least a dozen carefully selected individual shares to be truly diversified.
Because achieving diversification can be so challenging, some investors may find it easier to diversify within each asset class through the ownership of managed funds rather than through individual investments from each asset class. A managed fund is a company that pools money from many investors and invests the money in shares, bonds, and other financial instruments. Managed funds make it easy for investors to own a small portion of many investments. A share market index fund, for example, owns shares in thousands of companies. That's a lot of diversification for one investment!
The approach of spreading money among different investments to reduce risk is known as diversification. By selecting the right group
of investments, you may be able to limit your losses and reduce the
fluctuations of investment returns without sacrificing too much potential