What is Diversification?

Introduction

Diversification is a form of the word, diverse. Diverse means different or various as opposed to singular or one. It is a term that can also refer to a money management strategy. As a money management term, it refers to the dividing of money, more specifically, the dividing of money used for investing. It refers to multiple investments versus a singular investment.

Overarching Strategy

The strategy is simple. Spread the available pool of funds over a variety of assets from different classes. This avoids the all-eggs-in-one-basket syndrome.

The guiding principle is that smaller losses in multiple investments are offset by larger gains in others. If the investor incurs a loss in a technology stock, a greater gain in a medical care stock results in a net gain. An investor who has his total investment in that losing technology stock suffers a more severe loss.

Advantages

1. Increases Opportunity for Gains

Multiple investments bring the opportunity for realizing multiple gains. Market odds are more favorable in this scenario.

Though the gains may be smaller, over time, these smaller gains accrue. The accrual process increases the value of the investment portfolio.

2. Adds Flexibility

Instead of placing the account in jeopardy with a single investment, multiple investments give the account much-needed flexibility.

Flexibility is a strength. Diversification gives the account staying power when losses occur, and they are sure to occur.

3. Spreads and Minimizes Risk

Which is more detrimental to a small, personal investment account, small losses spread over time or a sudden, major loss? The question has one of those despised, obvious answers.

Spreading risk minimizes its overall impact on account balances. It has the effect of reducing loss long enough for gains to offset them. Think of it this way: what is the average daily loss of $100 spread over 20 days? It is $5 daily.

Now subtract this figure, $5, from a daily average gain of $5 or more. What is the net? It is a much smaller net loss over time and perhaps a net gain.

If that same $100 loss occurred with a single stock on a single day, the investor account has lost $100 in value. He would need to earn back that $100 just to get back to zero. Even then, his net gain is zero.

Disadvantages

1. Quickly Reduces Investment Amounts

Diversifying a set amount of funds means fewer funds available for each selected investment. It is a matter of simple division. A whole divided into equal parts limits the investment amount to 25 percent of the whole amount if the investor chooses four investments.

While the investor has spread the total investment funds, he cannot be as strong in either of them as he would be if he invested the entire pool into one stock. His lone investment is stronger in that it is larger.

2. Increases Research

Investing in multiple stocks requires more research. Each selected stock must be studied and assessed before making an investment decision. Selecting and focusing on one stock substantially reduces research.

3. Increases Monitoring Requirements

Increased investments require additional monitoring. Each stock must be watched closely to protect the investment, manage losses and protect gains. Four stocks means four times the monitoring as a single stock.

4. More Time Consuming

Additional research and monitoring logically consume more time than a single investment. If time is limited, multiple investments will be more cumbersome to manage.

Presuming equal time spent on each of the hypothetical investments, this represents four times more time spent than on a single investment. The U.S. Securities and Exchange Commission provides a much more detailed explanation of this investment strategy.

Summary

This terse article offers a snapshot to allow the reader to better understand this term and how it can be applied in the uncertain world of investing. Diversification is a more conservative investment strategy that can pay huge dividends for those who use it.