Introduction to Portfolio Diversification

Portfolio Diversification Portfolio diversification is a strategy that mixes a broad selection of investments within a single portfolio. Wikipedia gives this example of portfolio diversification: On a particular island the entire economy consists of two companies: one that sells umbrellas and another that sells sunscreen.

If a portfolio is completely invested in the company that sells umbrellas, it will have strong performance during the rainy season, but poor performance when the weather is sunny. The opposite occurs if the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio will be high performance when the sun is out, but will tank when clouds roll in.

To minimize the weather-dependent risk, the investment should be split between the companies. With this diversified portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible.

The idea behind the concept of diversification is to create a portfolio with multiple investments in order to reduce risk. One of the ways to reduce the risk in your portfolio is to include bonds and cash. You can also go with a balanced mutual fund, which combines stocks, bonds and sometimes a money market component. If you’re investing in stocks, you can choose a specific style, such as focusing on large, mid or small caps.

It is a commonly held view that a well-balanced portfolio with around 20 stocks diversifies away the maximum amount of market risk. Investing in too many stocks takes away the potential of big gainers having a significant impact on your bottom line. As Warren Buffett said, "wide diversification is only required when investors do not understand what they are doing."