Diversification is important since it helps investors to spread risks across diverse investment options.
It is easy to understand the importance of diversification by examining the basic definition of this strategy. Diversification is a strategy based on balancing between a large number of investments instead of concentrating all capital under a particular kind of investment.
Basically, thanks to diversification, one adds variety to the basket of assets by spreading the available funds between an increased number of asset classes. These increases in variety within a portfolio influence the situation with financial risks that an investor faces. Despite the seeming simplicity of the concept, as Kenneth Winans explains, achieving well-diversified portfolios is a challenging task.
If your portfolio is not diversified, you rely on one particular type of investment. If this investment’s performance is positive, you will get significant benefits. However, if the investment turns out to be bad (the risks of this event may vary), financial losses will be tangible due to overreliance on this particular investment.
The use of diversification in investing changes the distribution of financial risks and helps investors to strike the right balance between high- and low-risk investments. Even if some investments in a diversified portfolio cause negative returns on equity, financial losses will not be as massive as they would be without diversification. Apart from unsuccessful investments, there will also be profitable ones capable of neutralizing the effects of “bad” investments.
As the term suggests, diversification in finance allows investors to build portfolios that include securities involving diverse risks, and it is not based on refusing to make any high-risk investments. Low-risk investments in diversified portfolios act as a safety net and reduce overall losses if high-risk ones do not cause positive returns. At the same time, diversified portfolios do not exclude high-risk investments at all since they bring more money in case of success.