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What is diversification?
Diversification is when an investor manages risk by spreading out her investments across different asset classes. They’re a way to diversify a portfolio if its investments lie in the stocks of a single industry or asset class, because there’s the risk of losing money if an asset underperforms.
Diversification ensures that an investor’s portfolio doesn’t lean too heavily on one type of investment. That means investing in a variety of asset classes, such as stock in addition to material assets like real estate, or government bonds. Some people divide their investments over what’s called “industry sectors,” like health care or IT. Diversification even encompasses different kinds of stock classes, which run the gamut from stocks whose share price is constantly increasing to those that have slow and steady returns and pay dividends.
Because the value of an asset can be difficult to predict, diversification lets an investor spread money across any number of asset classes. That means less money might be allocated for a single asset and potentially reduce the investor’s gains, but it also means there’s less risk should an asset fail. It helps an investor not “keep all his eggs in one basket.”
An easy way to achieve diversification is by investing in an exchange-traded fund (ETF), which usually gathers many of the highest-performing companies across a variety of industries. The investor won’t have to worry about losing her investment even if a handful of those companies post losses.
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Khalid is an energy investor. He puts some money toward both oil and solar, even though those two commodities represent vastly different markets. He realizes that oil is underperforming in the market, but that it might pick up again later. As the price of oil starts to fall, Khalid’s investment is protected if solar stays steady or starts to rise in response, or vice versa. It’s unlikely that both commodities will fail at the same time, so the risk of losing his investment is lower.