Diversification

What is diversification?

It is when you have your investment assets in multiple, relatively uncorrelated assets. For example, lets say you own one stock -- Microsoft. Selling half of the Microsoft and buying a company that does business in a very different area -- say the Pfizer -- would be diversifying. You still wouldn't be very diversified, but you would be more diversified. Now, take that Microsoft stock and sell it to buy 15 more companies that are all in different areas and some other asset types like bonds and you will be truly diversified.

However, if you sold some Microsoft stock to buy Google, Apple, and Yahoo, then you wouldn't really be diversifying. Yes, you would be marginally more diversified, but your stocks would move up and down together more often than not. Don't make the mistake that adding a company or two to your portfolio automatically means you are diversified.

What are the advantages of diversification?

• It decreases your risk without decreasing your expected returns. All your eggs are not in one basket.
• It decreases the amount of fluctuation in your portfolio -- again without decreasing your expected returns.
• Big losers are balanced out by the big winners.

What are the disadvantages of diversification?

• Big winners are brought down by the big losers.
• It can be difficult to become diversified without index funds.

What is the best and easiest way to diversify?

Buy a low cost total US stock market index fund, an international index fund, and a total bond market index fund with Vanguard or another mutual fund company that has funds with low expense ratios. This is very simple and easy to do. It will also be low cost compared to buying and managing 10+ stocks.

return from diversification to index funds

beginner investing made easy home